Corporate Finance Q&a
Question 1 (1 mark)
The methods that a firm can use to evaluate a potential investment:
1) ‘Discounting’ Methods:
Net Present Value (NPV): the present value of the future after-tax cash flow minus the investment outlay made initially. The decision rule for the NPV as follows: invest if NPV> 0, do not invest if NPV< 0
Internal Rate of Return (IRR): calculates the interest rate that equates the present value of the future after-tax cash flows equal that investment outlay; then compared to the required rate of return, or hurdle rate, to determine the viability of the capital projects. The higher a project's internal rate of return, the more desirable it is to undertake the project.
Present Value Index (PVI) / Benefit-cost ratio /Profitability index: is the present value of a project’s future cash flows divided by the initial investment. The project will be accepted if this index is more than 1.0 and vice versa.
Hurdle rate: is the required rate of return in a discounted cash flow analysis, above which an investment makes sense and below which it does not. Often, this is based on the firm's cost of capital or weighted average cost of capital, plus or minus a risk premium to reflect the project's specific risk characteristics.
2) ‘Non-Discounting’ Methods:
Payback period: The period required to recover the original investment in a project. The payback is based on cash flows and we may accept the project if its payback period is less than some preset limit. Accounting rate of return (ARR) can be defined as follows: ARR =[pic]; the project is accepted if the AAR is greater than the preset rate.
3) Others: Sensitivity analysis, earnings multiple approach, real options approach, value at risk, and adjusted present value methods.
Question 2 (2 marks) When evaluating a potential investment opportunity, the NPV is a preferred method because of the fact that:
+ Based on the definition of NPV in
The methods that a firm can use to evaluate a potential investment:
1) ‘Discounting’ Methods:
Net Present Value (NPV): the present value of the future after-tax cash flow minus the investment outlay made initially. The decision rule for the NPV as follows: invest if NPV> 0, do not invest if NPV< 0
Internal Rate of Return (IRR): calculates the interest rate that equates the present value of the future after-tax cash flows equal that investment outlay; then compared to the required rate of return, or hurdle rate, to determine the viability of the capital projects. The higher a project's internal rate of return, the more desirable it is to undertake the project.
Present Value Index (PVI) / Benefit-cost ratio /Profitability index: is the present value of a project’s future cash flows divided by the initial investment. The project will be accepted if this index is more than 1.0 and vice versa.
Hurdle rate: is the required rate of return in a discounted cash flow analysis, above which an investment makes sense and below which it does not. Often, this is based on the firm's cost of capital or weighted average cost of capital, plus or minus a risk premium to reflect the project's specific risk characteristics.
2) ‘Non-Discounting’ Methods:
Payback period: The period required to recover the original investment in a project. The payback is based on cash flows and we may accept the project if its payback period is less than some preset limit. Accounting rate of return (ARR) can be defined as follows: ARR =[pic]; the project is accepted if the AAR is greater than the preset rate.
3) Others: Sensitivity analysis, earnings multiple approach, real options approach, value at risk, and adjusted present value methods.
Question 2 (2 marks) When evaluating a potential investment opportunity, the NPV is a preferred method because of the fact that:
+ Based on the definition of NPV in