Question

1) Identify and describe two (2) incremental cash flows from a proposed project such as expanding a product line or to launching a new product or service.

2) Define the payback, net present value, internal rate of return, and profitability index methods.

Answer 1

1) Two incremental cash flows are:

- Launching a new product or service would lead to increased sales which in turn lead to incremental revenues.

- Expanding a product line can cause economies of scale and result in cost reduction which in turn leads to incremental cash flows.  

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2)

Payback Period: The duration of time required for an investment to recover its initial outlay in terms of profits or savings. e.g. if a project costs $10,000 and saves $2500 a year, then the payback period is 4 years.

Net Present Value: Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. NPV is used to analyse profitability of an investment.

If NPV > 0, project earnings > anticipated costs and project is profitable.

If NPV < 0, project earnings < anticipated costs and project is not profitable.  

NPV is used to analyze an investment decision and give company management a clear way to tell if the investment will add value to the company. Typically, if an investment has a positive net present value, it will add value to the company and benefit company shareholders.

Internal Rate of Return (IRR): Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. The higher a project's internal rate of return, the more desirable it is to undertake.

If IRR > Discount rate, then project is profitable.

If IRR > Discount rate, then project is profitable.

Profitability Index: Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profibality index is a relative measure (i.e. it gives as the figure as a ratio).If IRR < Discount rate, then project is not profitable.

Profitability Index = PV of future cash flows Investment

A ratio of 1.0 is logically the lowest acceptable measure on the index, as any value lower than 1.0 would indicate that the project's PV is less than the initial investment.