Question

a) discuss three potential flows with the regular payback method.  Discuss whether or not the discounted payback method corrects all three flaws.

b) explain why the NPV of a relatively long-term project (one for which a high percentage of its cash flows occurs in the distant future) is more sensitive to changes in the WACC than that of a short-term project.

c) explain why IRR might be overly optimistic metric (give example of cash flows that might drive IRR artificially too high). What is the way to correct for inflationary IRR?

Answer 1

a) The regular payback method has three main flaws

1.Dollars received in differ-ent years are all given the same weight,

2.Cash flows beyond the payback yearare given no consideration regardless of how large they may be and lastly,

3. Unlike the NPV which shows us how much the project would increase the shareholder wealth or the IRR which would tell us how much a project would yield over the cost of capital, the payback method only tells us when the company would be receiving the investment back.

It corrects the first flaw however, it does nothing to correct the other two flaws.

b)  The NPV of a relatively long-term project, with a high percentage of its cashflows expected in the distant future, is more sensitive to changes in cost of capital than in the NPV of a short-term project

Because their payments willbe at the end of the project. The net present vale method discounts allcash flows at the projects cost of capital and then sums those cash flows at theend. Therefore is the payments are at the end of the project, any shift in the cost of capital, postive or negative, the NPV is more sensitive because thereis more time for change to occur.

c) IRR might be overly optimistic metric

A required rate of return is a rough estimate being made by the managers and the method of IRR is not completely based on required rate of return. Once IRR is found out, we can compare it with the hurdle rate. If the IRR is far away from the estimated required rate of return, the manager can safely take the decision on either side and also keep a room for estimation errors.

The real interest rate is 4%.

The inflation rate is 8%. What is the apparent interest rate,

i = i' + f + i'f = 0.04 + 0.08 + 0.04(0.08) = 12.32%