Question

Question 2:

Discuss various types of capital budgeting techniques. Also identify the most appropriate technique and justify with logical reasoning.

Question 3:

It is commonly recommended that the managers of a firm compare the performance of their firm to that of its peers. Increasingly, this is becoming a more difficult task. Explain some of the reasons why comparisons of this type can frequently be either difficult to perform or produce misleading results.

Question 4:

List and describe the three general areas of responsibility for a financial manager.

Question 5:

The managers of a firm wish to expand the firm's operations and are trying to determine the amount of debt financing the firm should obtain versus the amount of equity financing that should be raised. The managers have asked you to explain the effects that both of these forms of financing would have on the cash flows of the firm. Write a short response to this request.

Question 6:

Assume you are a credit manager in charge of approving commercial loans to business firms. Identify three aspects of a firm's cash flows you would review and explain the type of information you hope to gain from reviewing each of those five aspects.

Question 7:

Describe the major differences between individual and institutional investors.

Answer 1

Capital Budgeting is the process to determine whether to make Investments in a Plant, Machinery, Product etc. through firm's capitalization structure (debt, equity or retained earnings).

1. Payback Period Method : In this method the period in which an Investment generates cash to recover Initial Investment is measured. In a simple equivalent Annual cash flow,

   Payback period = Cash outlay (Investment) / Annual Cash Flow

This method while gives the time to reach positive cash flow, it misses the important parameters of time value of Money and Profitability and so it cannot be on a standalone basis be used to compare or measure Investments.

2. Accounting Rate of Return Method (ARR) : The rate of return is expressed as percentage of the earnings on an Investment. This method takes into account the complete project life cycle.

ARR = Average Income / Average Investment.

This method ignores the time value of money and also does not consider the time of the project.

4. Net Present Value (NPV) Method : It is a Discounted cash flow methods for evaluating capital investment proposals. The cash inflow that is expected at different periods of time is discounted at a particular rate known as Discount Rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. Discount Rate is typically the cost of Capital which varies across firms based on their alternative investments and expected rate of return.

NPV = Present Value of Cash Inflows - Present Value of Cash Outflows.

5. Internal Rate of Return : It is defined as the Rate at which Net present value becomes zero. It tries to arrive at a rate of interest at which funds invested could be repaid with the cash inflows. It is call Internal Rate since it depends solely on the success or failure of a project and not on any rate determined outside of the Investment.

6. Profitability Index : It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one.

Profitability Index = Present Value of Cash Flows /Initial Cash Outlay.

Most appropriate technique? I am not sure if the question is generic or specific to any previous question, I am providing below a generic response

Most frequently used methods are Payback period, IRR and NPV. The combination of these three is preferred.

Payback period helps to determine the timeline during which the cash positive happens. The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. A company may want to go ahead with a project if the IRR is calculated to be more than the company's required rate of return or it shows a net gain over a period of time. On the other hand, a company may want to reject a project if falls below that rate or return or it projects a loss over a period of time.The result is usually simple, which is why it is still commonly used in capital budgeting. But for any project that is long-term, that has multiple cash flows at different discount rates or that has uncertain cash flows—in fact, for almost any project at all—IRR isn't always an effective measurement. That's where NPV comes in.The NPV can be used to determine whether an investment such as a project, merger or acquisition will add value to a company.