Question

Define payback period. Explain how it can be used (5 lines).

List some advantages of payback period in capital budgeting decisions. Explain one of what you have listed (in 5 lines).

Explain (in 5 lines) one problem, pitfall, or disadvantage of using the payback.

Question Two has 40 points

2. Consider a project with a cost of $1000, with the following expected cash inflows, and a WACC of 16%.

Show your calculations by way of formulas, numerical values and if you like also by EXCEL for the following.

A. Calculate the present value of cash inflows.

B. Calculate the net present value of cash inflows.

C. Calculate the internal rate of return IRR.

D. Calculate the modified internal rate of return MIRR.

E. You will notice that IRR and MIRR are different in numerical values. Explain (in 5 lines) as to why they are different.

F. If you have to make a decision solely based on IRR or MIRR, which one would you choose and why? Explain in 5 lines.

Make sure you include your calculations by way of formulas, numerical values and if you like also by EXCEL

Question Three has 30 points

3.

A. Explain what is meant by the capital structure of an industrial firm (such as a manufacturing company). Be precise.

B. List components of the capital structure that you have defined above.

C. Are the items you have listed in part B above long term in nature (more than one year?)

D. Explain (in as much detail that you wish, including numerical analysis and graphs) the net income view or the traditional approach in regards to the relationship between the WACC and the value of the firm.

E. Explain (in 5 lines) why you would agree with the net income approach as listed in part D above.

F. Explain (in as much detail that you wish including numerical analysis and graphs) the operating income view or the neo-classical approach in regards to the relationship between the WACC and the value of the firm.

G. Explain (in 5 lines) why you would agree with the operating income or the neo-classical approach as listed in part D above.

Answer 1

Define payback period. Explain how it can be used

The payback period is the length of time required to recover the cost of an investment. The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions. The payback period ignores the time value of money (TVM), unlike other methods of capital budgeting such as net present value (NPV), internal rate of return (IRR), and discounted cash flow.
The payback period disregards the time value of money. Simply, it is determined by counting the number of years it takes to recover the funds invested. For example, if it takes five years to recover the cost of the investment, the payback period is five years. Some analysts favor the payback method for its simplicity. Others like to use it as an additional point of reference in a capital budgeting decision framework.

List some advantages of payback period in capital budgeting decisions. Explain one of what you have listed

This method is Easy and Simple

Pay-back method is easy to calculate and simple to understand. Its quick computation makes it a favourable among executives who prefer snap answers.

(2) Ranking of Projects:

This method is preferred by executives who like snap answers for the selection of the proposal. The projects are ranked in terms of their economic merits without much complications.

(3) It Stresses the Liquidity Objective

Because this method gives importance to the speedy recovery of investment in capital assets.

(4) Useful in Case of Uncertainty:

Pay-back method is useful in the industries which are subject to uncertainty, instability or rapid technological changes because the future uncertain­ty does not permit projection of annual cash inflows beyond a limited period. It reduces the possibility of loss through obsolescence.

(5) Handy Device or Method:

This method is handy device for evaluating investment proposals where procession in estimates of profitability is not important.

Explain (in 5 lines) one problem, pitfall, or disadvantage of using the payback

It ignores annual cash flow:

Pay-back method totally ignores the annual cash inflow after the pay-back period.

(b) It considers only the period of pay-back

Pay-back method does not consider the pattern of cash inflows or the magnitude and timing of cash inflows.

(c) It overlooks capital cost:

Pay-back method overlook the costs of capital i.e., interest factor which is an important consideration in making sound investment decisions.

(d) No rational basis of decision:

There is no rational basis for determining the minimum acceptable pay-back period. It is generally subjective decision of the management which creates so many administrative difficulties.

(e) It is delicate and rigid:

A slight change in operation cost may affect the cash inflow and as such pay-back period shall not be affected.

(f) This method over emphasises the importance of liquidity as a goal of capital expenditure decisions