1. Explain the differences and similarities between net present value (NPV) and
ID: 2727815 • Letter: 1
Question
1. Explain the differences and similarities between net present value (NPV) and the profitability index (PI).
2. You are analyzing a project and have prepared the following data:
Year Cash flow
0 $ -169,000
1 $ 46,200
2 $ 87,300
3 $ 41,000
4 $ 39,000
Required payback period 2.5 years Required return 8.50% Based on the net present value of this project, should you accept or reject the project?
3. Should financing costs be included as an incremental cash flow in capital budgeting analysis?
4. Explain the use of real and nominal discount rates in discounting cash flows. Which is used more often and why?
Explanation / Answer
Since required payback period for the project is 2.5 . calculation for payabck for the project gives 2.87 as below :
So the project is to be rejected.based on payback period.
However based on NPV , the project should be accepted as NPV of returns is $ 176,978 higher than the investment in Year 0.
financing costs be included as an incremental cash flow in capital budgeting analysis
Financing costs are ignored. This may be unrealistic. but it is not. Most of the time, analysts want to know the after-tax operating cash flows that result from a capital investment. Then, these after-tax cash flows and the investment outlays are discounted at the "required rate of return" to find the net present value (NPV). Financing costs are reflected in the required rate of return. If we included financing costs in the cash flows and in the discount rate, we would be double-counting the financing costs. So even though a project may be financed with some combination of debt and equity, we ignore these costs, focusing on the operating cash flows and capturing the costs of debt (and other capital) in the discount rate.
Under the nominal method, net cash flows in time t are calculated by the following formula:
Nominal Cash Flows at Time t = Real Cash Flows at Time t × (1 + Inflation Rate)t
Under the real method, real cash flows and real discount rate are used.
Relationship between nominal discount rate, real discount rate and inflation is given below:
Nominal Discount Rate
= (1 + Real Discount Rate)(1 + Inflation Rate) – 1
Real Discount Rate + Inflation Rate
Explain the use of real and nominal discount rates in discounting cash flows. Which is used more often and why?
The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.
It is often used when comparing investment projects of unequal lifespans. For example, if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.
The use of the EAC method implies that the project will be replaced by an identical project.
Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3-year project are compare to three repetitions of the 4-year project. The chain method and the EAC method give mathematically equivalent answers.
The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.
Year Cash flow Cumulative Inflows Outflow - Cumulative Payback (yr) 0 (169,000.00) 1 46,200.00 46,200.00 122,800.00 1.00 2 87,300.00 133,500.00 35,500.00 1.00 3 41,000.00 174,500.00 (5,500.00) 0.87 (35,500/41,000) 4 39,000.00 2.87Related Questions
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