1. What are some of the difficulties that might come up in actual applications o
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1. What are some of the difficulties that might come up in actual applications of the various criteria we discussed in Capital Budgeting? 1 2. Given the goal of maximization of firm value and shareholder wealth, we have stressed the importance of NPV. And yet, many financial decision-makers at some of the most prominent firms in the world continue to use less desirable measures sucvh as the payback period and average accounting return (AAR). Why do you think this is the case? 3. Discuss the relationship between NPV and IRR and explain the limitations of IRRExplanation / Answer
1. Challanges in Capital Budgeting:
A. Computing Relevant CashFlow: relevant cash flows are ideally incremental cash flow which can affect financial decision. There are many road bloackers to compute relevant cash flow. some of them are Sunk Cost, Allocated Cost, Opportunity Cost, net working capital, financing cost.Not identifying relevant cash flow sets equation incorrect.
B. Dealing with Inflation: Inflation tends to reduce the rates. Often it becomes difficult to compute real rate of return and nominal rate of return.
C. Choosing a discount rate: usually WACC is assumed to be discounted rate. There are some practical challenges in computation of WACC. Also based on risk of project it is not yet formulated whether WACC can be used as discounted rate.
D. Inherent Formula based problem of IRR decision rule
2. Payback and AAR act as first screener for evaluation of the project. It gives idea whether we need to give further time for investigation.
Certain firms are cash trapped. The major criteria for them is the return of cash. These companies dont have lot of capital to spend. Hence they use payback as method of calculation and decision making.
3. Discount rate at which NPV is zero is termed as IRR. if IRR is greater than discount rate,it is advisable to go for project since NPV will also be positive.
Common issues with IRR:
1. For investing or financing project IRR remains same. NPV may have different value. Hence IRR doesnt give correct picture in this case
2. Problem with Multiple rate of return: if project has unusual cash flow it may have multiple IRR.
3. IRR has scale problem. A high scaled project with marginally less IRR compared to less scaled project will not be prioritized.
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