Question

1. You and your colleague, Michael, are debating how to best handle a large expenditure on a piece of machinery as a capital budgeting decision. Michael says that his accounting background suggests that because the benefits of this large piece of machinery will be realized over the project's ten-year life, so should its costs. Discuss why you disagree or disagree with Michael.

2. What are some potential problems in using internal rate of return (IRR) for mutually exclusive projects?

3. Should financing costs be included as an incremental cash flow in capital budgeting analysis? Please explain.

Answer 1

Q1:

Michael is saying about the Matching principle in accounting, which says that the revenue or benefit earned through the use of an activity or equipment should be matched with the related expense incurred for generating the benefits. In accounting terms, we use depreciation of assets to show the theoretical expense incurred for creating such benefits.

Hence as per accounting principles and generally accepted revenue recognizing process it is better to agree with Michael.

Q2:

Some of the disadvantages of IRR are below;

• It gives absurd results when there are net cash out flows in between the forecasted years. IRR works well when there is only one cash outflow at the beginning and rest all are cash inflows. If there are intermittent cash inflows and outflows, it either wont give a conclusive result or sometimes give 2 IRR values
• IRR method ignores the change in reinvestment rates and assumes that earnings are reinvested in IRR rate
• It doesnt consider the time span of receiving the return. IRR can favor a long project which eventually stabilize in its cash flow over a short project which can easily give positive npv within a short span of time.
• It ignore hurdle rates in a project
• It cant be solved using normal calculations and should use iterative approach through software or financial calculators

Q3:

Incremental cash flows are the additional cash a firm can generate by taking a new project through its operations.Financing cost should not be included as an incremental cashflows. This is because financial cost is already accounted for as cost of capital used for discounting cash flows.