Question

1. Assume you are a banker evaluating a loan (long-term) request from Fisher & Paykel Healthcare for $70 million. What would be your concerns in deciding on approval or denial of the loan request?

2. Why the payback period method and internal rate of return(IRR) do not give answers which are consistent with each other, for the accept /reject decision. Which method should be employed?.why?

Answer 1

1: My first concern would be the solvency of the firm. This will ensure that the loan is repaid. For this, I will assess its capital structure ratios such as Debt Equity ratio to understand the level of debt it has already undertaken. Also I would be concerned about the long term sustainability of the firm. For this, I will assess the profitability ratios such as net margin ratio. I will also be looking at the capacity of the firm to repay interest by looking at Times interest earned,

2:

The payback period method ignores the time value of money and the only criteria used in this method is whether the initial capital is paid back within the time required by the management. The internal rate of return specifies the rate of return from a particular investment. Hence it takes into account all the cash flow was involved. The payback period method may reject a particular proposal, even if it has high returns but after the specified period. The IRR method is used to decide upon a particular proposal, depending on whether the return is higher or lower than the cost of capital. Moreover this method cannot be used when there are repeated changes in the sign of cash flows.

Ideally the net present value method is most suitable because it takes into account the time value of money and also all cash flows. It computes the value added to the business by the proposal.