Question

1. Explain M&M proposition 1

2. What is Profitability Index and its pros and cons?

3. What is Payback Period? And its pros and cons?

4. What is NPV? And is it pros and cons?

5. Define financial leverage and explain what an unlevered company means.

Answer 1

1]

M&M proposition 1 assumes perfectly efficient markets and no taxes. In this proposition, the firm's capital structure does not impact the value of the firm. In other words, the value of the unlevered firm (financed only by equity) is equal to the value of the levered firm (financed by equity and debt)

The value of a firm is the present value of its future cash flows. As there are no taxes, the firm does not have any tax shield on interest payments (interest payments are tax deductible). Hence there is no difference in values between firms with debt and without debt.

2]

Profitability Index = (NPV + Initial investment) / Initial investment.

It measures whether an investment creates or destroys value. If the PI is more than 1, it means that NPV > 0, and the investment creates value.   If the PI is less than 1, it means that NPV < 0, and the investment destroys value.  

Pros :

• It provides a single number which is easy to interpret
• It takes into account time value of money

Cons :

• It requires an estimate of cost of capital, which is complex
• In ranking mutually exclusive projects with different initial investments, it may not lead to a correct decision

3]

Payback period measures the time taken for the net cash flows of the project to equal the initial investment. In other words, it is the time taken for the cumulative net cash flows of the project to equal the initial investment.

Pros :

• Easy to calculate

Cons :

• It does not show the profitability of the project
• It does not consider time value of money

4]

NPV is the present value of all cash flows (inflows and outflows) of a project. The discount rate used is the required return on the project. If the NPV is positive, the project creates value, and if the NPV is negative, it destroys value.

Pros :

• It considers time value of money and timing of cash flows
• It indicates whether a project is profitable, and whether it creates value

Cons :

• Assumes a constant discount rate over time
• A lot of assumptions involved in NPV analysis