Question

Question 1: Patrick Johnson is a manager for Star Company. He tells you that his company always maximizes profitability by accepting the investment opportunity with the highest internal rate of return. Explain to Mr. Johnson how his company may improve profitability by sometimes selecting investment opportunities with lower internal rates of return.

Question 2: What typical cash inflow and outflow items are associated with capital investments? Explain.

Answer 1

1. The manager must be explained that IRR alone must not influence an investment decision as there are other factors that determine if the project must be accepted or not . The other prime criterion influencing the project is acceptable or not is the Net Present value of the investment. If the NPV is positive, the company can still go ahead in spite of the IRR being lower. Also, those projects with lower IRR add value to the company over time if the duration of the investment is longer. A higher IRR means that the company is taking higher risk and conversely a lower IRR will reduce the overall risk for the business.

2.

Cash inflows:

(I) Incremental revenue : It is the additional revenue generated due to employment of the additional capital assets in the business.

(ii) Cost savings: The savings associated with the use of new assets or replacement of assets

(iii) Salvage value : It is the value of the capital asset at the end of its useful life.

(iv) Working capital recovery: The working capital invested while the asset is in operation is earned through the revenues generated through the deployment of the capital asset.

Cash outflow:

(I) Initial investment: The cash outflow associated with the purchase of a capital asset that include the purchase price, transportation, installation and all other costs to bring the asset to its intended use.

(ii) Incremental expenses :It is the additional expenses incurred due to employment of the additional capital assets in the business.

(iii) Working capital requirement: The investment in working capital required before the capital asset starts to generate revenues.

Any doubt please comment, If it helped you, please give a thumbs up.