Principles of Finance Notes
Theory Questions
Explain why the NPV approach is preferred to the IRR approach (2006)
The NPV approach takes into account the timing of cash flows and the IRR does not. For example if you took 2 projects that required the same initial outlay and had the same cash inflows for the same period of time but one project was deferred for one year, using the NPV we would have different values but the IRR would give us the same.
The NPV approach takes into account the scale of the project and the IRR does not. For example
The NPV approach can include multiple positive and negative cash flows in its calculations whereas the IRR cannot. The IRR is the discount rate that makes a project break even. If market conditions
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A firm's choice of investments are separate from its owner's attitudes towards the investments.
2. It is possible to separate a firm's investment decisions from the firm's financial decisions.
The first point means that the primary goal of any firm is to maximise its value, regardless of the attitudes of the firms owners. The second point means that a firm's value is not determined by the way it is financed or the dividends paid to the firm's owners.
Explain the concepts of business risk and financial risk. (/2010)
Business risk is the possibility that a company will have lower than anticipated profits, or that it will experience a loss rather than a profit. Business risk is influenced by competition, economic climate, government regulation amongst others. A company with a higher business risk should choose a capital structure that has a lower debt ratio to ensure that it can meet its financial obligations at all times. The ratios used to evaluate business risk include the contribution margin ratio, operating leverage ratio, financial leverage ratio and total leverage ratio.
Financial risk is the possibility that shareholders will lose money when they invest in a company that has debt, if the company's cash flow proves inadequate to meet its financial obligations. When a company uses debt financing, its creditors will be repaid before its shareholders if the company becomes insolvent. Investors can use a number of ratios to evaluate financial
d. internal rate of return (IRR) the discount rate that forces a project’s NPV to equal zero. The project should be accepted if the IRR is greater than the cost of capital.
At the end all the risk are finance related, because the liability’s cost money and this will have an effect in the company’s earnings, so what is important is not only to try to avoid such events but also to be prepare in case they happen and have a plan, is like the saying “Hope for the best but be prepare for the worst”.
Which statement concerning the net present value (NPV) of an investment or a financing project is correct?
Risk is defined as the probability that a company will become insolvent and will not be able to meet its obligations when they become due for payment. The profitability versus
In the character Adam Trask in the Novel East of Eden, John Steinbeck creates a fragile son trying to impress his war obsessed father while dealing with his aggressive younger brother. As Adam’s father tries to prepare them for the army, Adam learns that he does not want to follow in his father's footsteps and does not want to face the hardship of war.
Gladiators were slaves who fought to the death in the arenas of ancient Rome. What were their lives like, and how did they survive? Even though gladiator games were popular, gladiators themselves lived complicated and violent lives. Gladiatorial games started in Rome over 300 years before the Roman Colosseum was built. Gladiator fights started when Decimus Junius Scaeva began the gladiatorial combat to honor the memory of his father at a funeral. The fight took place in the Forum Boarium, the cattle market in Rome. After, this type of fighting became very popular. More and more gladiator fights took place at funerals. The fights became bigger and more elaborate because of their popularity. At the funeral of P. Licinius Crassus (Pontifex Maximus)
Net Present Value (NPV) calculates the sum of discounted future cash flows and subtracting that amount with the initial investment of the project. If the NPV of a project results in a positive number, the project should be undertaken. It is the most widely used method of capital budgeting. While discount rate used in NPV is typically the organization’s WACC, higher risk projects would not be factored in into the calculation. In this case, higher discount rate should be used. An example of this is when the project to be undertaken happens to be an international project where the country risk is high. Therefore, NPV is usually used to determine if a project will add value to the company. Another disadvantage of NPV method is that it is fairly complex compared to the other methods discussed earlier.
Account for time. Time is money. We prefer to receive cash sooner rather than later. Use net present value as a technique to summarize the quantitative attractiveness of the project. Quite simply, NPV can be interpreted as the amount by which the market
NPV and IRR: When examining the NPV and the IRR of the Merseyside project, the numbers were very attractive. It had a positive net present value and an IRR above 10 percent. By these numbers, along with others,
3. The NPV method is better because it shows the size of the project so you can see how much value a project has not just a percentage. You could have a higher percentage but a much lower value and you would still go for the lower percentage.
In 2009, Harper Lee’s bestselling novel To Kill a Mockingbird was banned in St. Edmund Campion Secondary School in Brampton, Ontario after a parent complained about the use of inappropriate language in the novel (Javed 2009). To Kill A Mockingbird, considered one of the best novels of the 20th century, is also one of the most controversial. According to the American Library Association’s Office for Intellectual Freedom, it is one of the most challenged and banned classic novels (Downs 2016). Although this novel has been banned in many schools and school boards across Canada and the United States because of “inappropriate racial and sexual content”, To Kill a Mockingbird thoroughly bespeaks the absurdity of the inequality and discrimination
IRR uses all cash flows and incorporates the time value of money. When evaluating independent projects, IRR will always lead to the same decision as NPV. Because IRR assumes that cash flows will be reinvested at the internal rate of return, which is not always or even usually the case, it can rank mutually exclusive projects incorrectly. With certain patterns of cash flows, the IRR equation has more than one solution, which confuses the decision rule. IRR is slightly more
The internal rate of return (IRR) and the net present value (NPV) techniques are 2 investment decision tools that satisfy the 2 major criteria for the correct evaluation of capital projects. This criterion is that the techniques should incorporate the use of cash flows and the use of the time value of money. This makes them viable techniques for evaluating investment proposals.
NPV analysis uses future cash flows to estimate the value that a project could add to a firm’s shareholders. A company director or shareholders can be clearly provided the present value of a long-term project by this approach. By estimating a project’s NPV, we can see whether the project is profitable. Despite NPV analysis is only based on financial aspects and it ignore non-financial information such as brand loyalty, brand goodwill and other intangible assets, NPV analysis is still the most popular way evaluate a project by companies.
Internal rate of return (IRR) is the discount rate that makes NPV equal to zero. It is also called the time-adjusted rate of return.