Financial Management – Theory and Application

SECTION A

The directors of M &R plc wish to expand the company’s operations. However, they are not prepared to borrow at the present time to finance capital investment. The directors have therefore decided to use the company’s cash resources for the expansion programme. Three possible investment opportunities have been identified. Only £600,000 is available in cash and the directors intend to limit the capital expenditure over the next 12 months to this amount. The projects are not divisible and none of them can be postponed. The following cash flows do not allow for inflation, which is expected to be 12% per annum constant for the foreseeable future. Expected net cash flows (including residual values)

Initial investment Year 1 Year 2 Year 3

Project £ £ £ £

A -310,000 96,000 113,000 210,000

B -115,000 45,000 42,000 47,000

C -36,000 -41,000 -23,000 127,000

QUESTION 1

Explain how inflation affects the rate of return required on an investment project, and the distinction between a real and a nominal approach to the evaluation of an investment project under inflation.

SOLUTION

It is very vital to adapt investment assessment methods to cope with the trend of pricemovement. Inflation represents the rate at which the real value of an investment is eroded and the loss in purchasing power over time. Inflation portrays to investors exactly how much of a return their investments will provide to position them to for the purposes of maintaining their standard of living. Inflation erodes an investment annual rate of return. When inflation rate is higher than the rate of return, the investor loses money on their investment. Rising inflation rate will lead to increase in the rate of return required by the firm’s security holders.

Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy. Inflation can impact return on investment (ROI) in numerous ways and can boost as well as diminish the final return figure. It erodes an investment annual rate of return. The higher the inflation rate the lower the value of money. That means the investor loses money when inflation rate is higher than the rate of return. Thus, rising inflation rate imply to increase the rate of return required by the firm’s security holders. Inflation also changes the benchmark against which ROI must be measured. While a particular ROI level maybe satisfactory in a low-inflation environment, the same ROI may fail to satisfy investors when inflation is high (1).

A nominal approach to investment evaluation discounts nominal cash flows with the nominal cost of capital. Nominal cash flows in this case are gotten by inflating forecasts values from current price estimate for example by using specific inflation! This is through inflating protecting cash flows by different inflation rates for purposes of generating nominal protect cash flows.

A nominal (money terms) approach to investment appraisal discounts nominal cash flows with a nominal cost of capital. Nominal cash flows are found by inflating forecast values from current price estimates, for example, using specific inflation. Applying specific inflation means that different project cash flows are inflated by different inflation rates in order to generate nominal project cash flows.

A real approach to investment evaluation discounts real cash flows with the real cost of capital. The real cash flows are arrived by deflating nominal cash flows by general inflation rate. Also, the real cost of capital is found by deflating the nominal cost of capital by the general inflation rate, by using the common known fisher equation.%&’real discount rate(%;’inflation rate( ) %&’nominal discount rate(

A real terms approach to investment appraisal discounts real cash flows with a real cost of capital. Real cash flows are found by deflating nominal cash flows by the general rate of inflation. The real cost of capital is found by deflating the nominal cost of capital by the general rate of inflation, using the Fisher equation:

(1 + real discount rate) x (1 + inflation rate) = (1 + nominal discount rate)

The net present value for an investment project does not depend on whether a nominal terms approach or a real terms approach is adopted, since nominal cash flows and the nominal discount rate are both discounted by the general rate of inflation to give real cash flows and the real discount rate, respectively. Both approaches give the same net present value (2).

1. Calculate the expected net present value and profitability indexes of the three projects;

SOLUTION

Taking the inflation into account and using the relationship of Fisher (3):

Rn = Ri + Rr (1+ Ri )

Where Rn is the Nominal rate of return (=16%)

Ri is the rate of inflation (=12%)

Rr is the Real rate of return

The real rate of return is calculated as bellow:

Rr =Rn-Ri 1+ Ri = 0.16-0.12 1+ 0.12 =0.0357 =3.6 %

Using this real rate of return, NPV for project A B and C are calculated as bellow:

Project A:

NPV=-NCF0+ t=13NCFt(1+Rr)t = – 310000 + 96000(1.036)1 + 113000(1.036)2 + 210000(1.036)3 = –

310000+92664.09+105283.17+ 188860.02 = 76807.11

Project B:

NPV=-NCF0+ t=13NCFt(1+Rr)t = – 115000 + 45000(1.036)1 + 42000(1.036)2 + 47000(1.036)3 = – 115000

+43436.29+39131.80+ 42268.67 = 9836.76

Project C:

NPV=-NCF0+ t=13NCFt(1+Rr)t = – 36000 + -41000(1.036)1 + -23000(1.036)2 + 127000(1.036)3 = -36000-39575.29-

21429.32+ 114215.34 = 17210.73

Using Excel sheet, the results are as shown below.

Cash flow

Project A Project B Project C

Year 0 -310000 -115000 -36000

Year 1 96000 45000 -41000

Year 2 113000 42000 -23000

Year 3 210000 47000 127000

Cost of capital 0.036 0.036 0.036

NPV 76,807.28 9,836.76 17,210.74

Profitability indexes of the project:

Profitability index = PV of future cash flows Initial investment

Project A

Profitability index = 92664.09+105283.17+188860.02 310000 = 386807.28 310000 = 1.25

Project B

Profitability index = 43436.29+39131.80+42268.67 115000 = 124836.76 115000 = 1.09

Project C

Profitability index = -39575.29-21429.32+114215.34 36000 = 53210.73 36000 = 1.48

2. Comment, on which project should be chosen for the investment, assuming the company can invest surplus cash in the money market at 10 per cent.

Answer:

As compared to projects B and C, project A should be chosen for investment because of its higher net present value. Investing surplus cash in the money market at 10% will provide a higher return than the value of projects B and C.

Discuss whether the company’s decision not to borrow, thereby limiting investment expenditure, is in the best interests of its shareholders.

Answer:

Decision not to borrow is really limiting the investment expenditure, but it is in the best interests of shareholders. Since the shareholders want to keep full control on the company. Borrowing would weaken the shareholders control of the company by sharing it with the lenders.

SECTION B

True/False:

Q1. At some level, an additional increase in the size of the firm’s total capital budget may lead to a decrease in the NPVs of all the investments being considered.

Answer: True

Q2. Sole proprietorship is an owner’s only business.

Answer: False

Q3. The main function of the capital budget is to forecast the funds needed for future investments that must be raised through external funding, that is, by selling stock or bonds.

Answer: False

Q4. When a project’s NPV exceeds the project’s IRR, then the project should be accepted.

Answer: False

Q5. When examining two mutually exclusive projects, the financial manager should always select that project whose internal rate of return is the highest provided the projects have the same initial cost.

Answer: True

Multiple Choice

Q6. Which of the following is correct? With regard to information, a central idea of fairness suggests that

a) Outsiders should not be allowed to trade since, by definition, they are at a disadvantage.

b) Insiders should never be able to trade.

c) Decisions should be made on an even playing field.

d) Insiders should be able to trade whenever they want.

Answer: c)

Q7. Identify which of the following capital budgeting methods might not consider the salvage value of a machine being considered for purchase?

a. Internal rate of return.

B. Net present value.

c. Payback.

d. Discounted payback.

e. Answers c and d are both correct.

Answer: e)

Q8. When the calculated NPV is negative, then which of the following must be true? The discount rate used is

a. Equal to the internal rate of return.

b. Too high.

c. Greater than the internal rate of return.

d. Too low.

e. Less than the internal rate of return.

Answer: c)

Q9. Which of the following indices is not a broad market average index?

a) CAC-40

b) DAX

c) FTSE 100

d) Amex Oil Index

Answer: b)

Q10. Use the following table to calculate the expected return for the asset.

Return Probability

0.10 0.25

0.20 0.50

0.25 0.25

What is the asset’s expected return?

a) 20.00%

b) 18.75%

c) 17.50%

d) 15.00%

Answer: b)

Q11. Evaluate the two mutually exclusive capital budgeting projects that have the following characteristics:

Cash Flows

Year Project Q Project R

0 $(4,000) $(4,000)

1 0 3,500

2 5,000 1,100

IRR 11.8% 12.0%

If the firm’s required rate of return (k) is 10 percent, which project should be purchased?

a. Both projects should be purchased, because the IRRs for both projects exceed the firm’s required rate of return.

b. Neither project should be accepted, because the IRRs for both projects exceed the firm’s required rate of return.

c. Project Q should be accepted, because its net present value (NPV) is higher than Project R’s NPV.

d. Project R should be accepted, because its net present value (NPV) is higher than Project Q’s NPV.

e. None of the above is a correct answer.

Answer: c)

Q12. Which of the following statements is false?

a. The NPV will be positive if the IRR is less than the required rate of return.

b. If the multiple IRR problems do not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.

c. When IRR = k (the required rate of return), NPV = 0.

d. The IRR can be positive even if the NPV is negative.

e. The NPV method is not affected by the multiple IRR problems.

Answer: a)

Q13. Two projects being considered are mutually exclusive and have the following cash flows:

Year Project A Project B

0 -$50,000 -$50,000

1 15,625 0

2 15,625 0

3 15,625 0

4 15,625 0

5 15,625 99,500

If the required rate of return on these projects is 10 percent, which would be chosen and why?

a. Project B because of higher NPV.

b. Project B because of higher IRR.

c. Project A because of higher NPV.

d. Project A because of higher IRR.

e. Neither, because both have IRRs less than the cost of capital.

Answer: a)

Q14. Which of the following is correct? In computing the NPV of a capital budgeting project, one should NOT

a) Estimate the cost of the project.

b) Ignore the salvage value.

c) Make a decision based on the project’s NPV.

d) Discount the future cash flows over the project’s expected life.

Answer: b)

Q15. Which of the following is most correct? The modified IRR (MIRR) method:

a. Always leads to the same ranking decision as NPV for independent projects.

b. Overcomes the problem of multiple rates of return.

c. Compounds cash flows at the required rate of return.

d. Overcomes the problem of cash flow timing and the problem of project size that leads to criticism of the regular IRR method.

e. Answers b and c are both correct.

Answer: e)

Q16. Which of the following is correct? Disadvantages of the payback method include the following.

a) It ignores the time value of money.

b) It is inconsistent with the goal of maximizing shareholder wealth.

c) It ignores cash flows beyond the payback period.

d) All of these.

Answer: d)

Q17. Which one of the following statements about IRR is NOT true?

a) The IRR is the discount rate that makes the NPV greater than zero.

b) The IRR is a discounted cash flow method.

c) The IRR is an expected rate of return.

d) None of these.

Answer: a)

Q18. Which of the following is correct? When estimating the cost of debt capital for the firm we are primarily interested in

a) The cost of short-term debt.

b) The cost of long-term debt.

c) The coupon rate of the debt.

d) None of these

Answer: b)

Q19. A corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year10. This investment will cost the firm $150,000 today, and the firm’s required rate of return is 10 percent. Assume cash flows occur evenly during the year, 1/365th each day. What is the payback period for this investment?

a. 5.23 years

b. 4.86 years

c. 4.00 years

d. 6.12 years

e. 4.35 years

Answer: b)

Q20. Which of the following is correct? Disadvantages of going public include all EXCEPT

a) The transparency that results from this compliance can be costly for some firms.

b) The costs of complying with ongoing listing and disclosure requirements.

c) The high cost of the IPO itself.

d) Managers’ tendency to focus on long-term profits.

Answer: d)

References

http://smallbusiness.chron.com/inflation-impact-return-project-77163.htmlhttp://www.accaglobal.com/content/dam/acca/global/PDF-students/acca/f9/exampapers/f9_2017_jun_a.pdf

INFLATION INFLUENCE ABOUT INVESTMENT DECISION, by Dorel Berceanu and Anca B?ndoi http://www.oeconomica.uab.ro/upload/lucrari/1020081/33.pdfProject evaluation under inflationary conditions, by Halil SARIASLAN, http://dergiler.ankara.edu.tr/dergiler/42/453/5100.pdf