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Answer C
The budget we prepaired is under the assumption that all inflow as well as outflows are occuring uniformally during the month. In the given scenario since all the payments need to be paid on 5th of the month whereas corrensponding inflows will come uniformally during the month this situation will crate cashflow mismatch for the temperory period. Hence to comeup this mismatch company will have to take the shortterm finance facility from bank. In the first month company will have to take a finace of total outflow amount - 5 days receipts of cash in that month. Then the same can be repaid by end of the month then again on 5th of next month finance of outflow-5days inflow. In this way the estimate of cash budget can be prepared.
Answer d
In no seasonal period company will continue to produce the goods which will require the cash, For this requiremet company will have to take finance. Now debt will increase and debt ratio will aslo increase. Since due to production there will be increase in stock and current ratio will aslo increase which will result in working capital positive gap.
Due to seasonal business there will be working capital mismatch. On overall yearly basis the credit position of the company will be the same. In this type of scenario bank sanction the short term loans but not longterm.
The budget we prepaired is under the assumption that all inflow as well as outflows are occuring uniformally during the month. In the given scenario since all the payments need to be paid on 5th of the month whereas corrensponding inflows will come uniformally during the month this situation will crate cashflow mismatch for the temperory period. Hence to comeup this mismatch company will have to take the shortterm finance facility from bank. In the first month company will have to take a finace of total outflow amount - 5 days receipts of cash in that month. Then the same can be repaid by end of the month then again on 5th of next month finance of outflow-5days inflow. In this way the estimate of cash budget can be prepared.
Answer d
In no seasonal period company will continue to produce the goods which will require the cash, For this requiremet company will have to take finance. Now debt will increase and debt ratio will aslo increase. Since due to production there will be increase in stock and current ratio will aslo increase which will result in working capital positive gap.
Due to seasonal business there will be working capital mismatch. On overall yearly basis the credit position of the company will be the same. In this type of scenario bank sanction the short term loans but not longterm.
1. Increase in household savings increases the supply of loanable funds that leads to decrease in nominal interest rate.
2. Increase in demand for funds increases the demand for loanable funds that results in increase in nominal interest rate.
3. Increase in budget deficit decreases national savings and thus supply of loanable funds decreases. This results in increase in nominal interest rate.
4. Nominal interest rate = real interest rate + expected inflation
Thus increase in expected inflation leads to increase in nominal interest rate
2. Increase in demand for funds increases the demand for loanable funds that results in increase in nominal interest rate.
3. Increase in budget deficit decreases national savings and thus supply of loanable funds decreases. This results in increase in nominal interest rate.
4. Nominal interest rate = real interest rate + expected inflation
Thus increase in expected inflation leads to increase in nominal interest rate
last onef. The crossover rate is nothing but the discount rate at which two projects have the same Net Present Value (NPV). This rate is mainly used in capital budgeting to show when one project becomes superior/lower than the other project (while comparing two projects). Like in the above case, if the rate of return is less than 13.5252% then Project 1 ($5, $10, $15, $20) would be better than Project 2 and if it is lower than 13.5252% then Project 2 would be better than Project 1.
You can calculate NPV at different rates for both projects to cross verify the same.
g. Yes it is very much possible for conflicts to exist while comparing NPV and IRR of two projects. This may happen due to many reasons, to quote a few,
---i Very different pattern of cash flows, consider the following example,
r=10%
Year Project A Project B
0 -8000 -8000
1 3000 0
2 3000 0
3 4000 0
4 4000 18000
NPV $2,676.30 $3,903.86
IRR 25% 22%
---ii Different size of investment in both projects, consider the following:
r= 10%
Year Project A Project B
0 -8000 -25000
1 3000 9000
2 3000 9000
3 3000 9000
4 3000 9000
NPV $1,372.36 $3,207.99
IRR 18% 16%
We can clearly see the conflict in both the cases. In case of such conflicts, the project with higher NPV should be chosen almost always. The main reason for this is that, the NPV uses a pre determined rate to examine whether a project would be fruitful, whereas to calculate IRR we have to use hit and trial method to arrive at an approximate rate at which NPV is zero.
The conflict can also occur if both projects have different life spans.
h. Payback period is the time taken to recover the initial investment in a project. Discounted Payback period is calculated by discount the future cash flows to their present value (r=WACC) and then calculating the time taken to recover the initial investment. Just keep on adding the cash flows till you reach the initial investemnt amount.
Calculation:
r= 10%
Year Project A Project B Discounted CF A Discounted CF B
0 -30 -50
1 5 20 4.55 18.18
2 10 10 8.26 8.26
3 15 8 11.27 6.01
4 20 6 13.66 4.10
NPV $7.04 ($12.22)
IRR 19% -6%
Regular Payback 3 years Initial investment not recovered
Discounted Payback Between 3 & 4 yrs Initial investment not recovered
In both cases (general/discounted) we can see that Project A is better as initial investment is not recovered for Project B in both caes. Note that NPV & IRR are shown here just for information, there is no need to calculate them to find out the PBP.
You can calculate NPV at different rates for both projects to cross verify the same.
g. Yes it is very much possible for conflicts to exist while comparing NPV and IRR of two projects. This may happen due to many reasons, to quote a few,
---i Very different pattern of cash flows, consider the following example,
r=10%
Year Project A Project B
0 -8000 -8000
1 3000 0
2 3000 0
3 4000 0
4 4000 18000
NPV $2,676.30 $3,903.86
IRR 25% 22%
---ii Different size of investment in both projects, consider the following:
r= 10%
Year Project A Project B
0 -8000 -25000
1 3000 9000
2 3000 9000
3 3000 9000
4 3000 9000
NPV $1,372.36 $3,207.99
IRR 18% 16%
We can clearly see the conflict in both the cases. In case of such conflicts, the project with higher NPV should be chosen almost always. The main reason for this is that, the NPV uses a pre determined rate to examine whether a project would be fruitful, whereas to calculate IRR we have to use hit and trial method to arrive at an approximate rate at which NPV is zero.
The conflict can also occur if both projects have different life spans.
h. Payback period is the time taken to recover the initial investment in a project. Discounted Payback period is calculated by discount the future cash flows to their present value (r=WACC) and then calculating the time taken to recover the initial investment. Just keep on adding the cash flows till you reach the initial investemnt amount.
Calculation:
r= 10%
Year Project A Project B Discounted CF A Discounted CF B
0 -30 -50
1 5 20 4.55 18.18
2 10 10 8.26 8.26
3 15 8 11.27 6.01
4 20 6 13.66 4.10
NPV $7.04 ($12.22)
IRR 19% -6%
Regular Payback 3 years Initial investment not recovered
Discounted Payback Between 3 & 4 yrs Initial investment not recovered
In both cases (general/discounted) we can see that Project A is better as initial investment is not recovered for Project B in both caes. Note that NPV & IRR are shown here just for information, there is no need to calculate them to find out the PBP.
i. Payback method is although very easy to calculate but is not a very reliable tool for capital budgeting. This is because it doesn't give us the exact results. We just get an approximate figure and a vague idea as to when our initial investment would be recovered. Since the basic rule of investment is to atleast reach the break even point, PBP may be used then, but it becomes difficult to actually judge that whether a project is profitable or how profitable. On the other hand NPV/ IRR are much better tools for capital budgeting decisions because NPV provides the absolute figure that the project will earn in the future and on comparing IRR with the Cost of Capital we can decide whether a project is profitable or not. Hence, these two provide more reliable resuls than PBP.
j. MIRR is the Modified Internal Rate of Return, which assumes that the projects cash flows (positive) are re invested at the WACC, and the initial cash flow (initial investment and negative cash flows) are financed at the company's financing cost. It is used to rank two or more projects, like the IRR. But MIRR is used to overcome the problems with IRR, like IRR assumes reinvestment of all cash flows at the internal rate of return only which is a bit unrealistic in practical scenario. Unlike IRR, MIRR gives a single solution.
k. The first part of the question was already answered in part g. Although NPV method is better but it is still more complicated than IRR. There are assumptions in NPV which are more complex than IRR. And, besides IRR can be used to rank the projects which are not mutually exclusive and the company can choose both/all at the same time. This may sometimes be a better option. However, to rank mutually exclusive projects, NPV still remains the best method.
j. MIRR is the Modified Internal Rate of Return, which assumes that the projects cash flows (positive) are re invested at the WACC, and the initial cash flow (initial investment and negative cash flows) are financed at the company's financing cost. It is used to rank two or more projects, like the IRR. But MIRR is used to overcome the problems with IRR, like IRR assumes reinvestment of all cash flows at the internal rate of return only which is a bit unrealistic in practical scenario. Unlike IRR, MIRR gives a single solution.
k. The first part of the question was already answered in part g. Although NPV method is better but it is still more complicated than IRR. There are assumptions in NPV which are more complex than IRR. And, besides IRR can be used to rank the projects which are not mutually exclusive and the company can choose both/all at the same time. This may sometimes be a better option. However, to rank mutually exclusive projects, NPV still remains the best method.
A) Based on EAR, Bank A should be used.
B) Yes. If funds may have to be withdrawn during the year with the added assumption that Banks pay interest only if the deposit is held during the entire period, then Bank B should be chosen.
If Bank B is chosen the compounding period is a day, because of which it does not matter when the deposit is withdrawn. One will get interest upto the day of withdrawal that too compouded daily.
In the cas of Bank A, if the amount is withdrawn before the end of the year no interest would be paid for the year.
Hence, Bank B is the safest option, though EAR is lower.
B) Yes. If funds may have to be withdrawn during the year with the added assumption that Banks pay interest only if the deposit is held during the entire period, then Bank B should be chosen.
If Bank B is chosen the compounding period is a day, because of which it does not matter when the deposit is withdrawn. One will get interest upto the day of withdrawal that too compouded daily.
In the cas of Bank A, if the amount is withdrawn before the end of the year no interest would be paid for the year.
Hence, Bank B is the safest option, though EAR is lower.
Sales Price $9,456,000
Less: Tax @15% ($1,418,400)
Effective sales Price $8,037,600
Less: Purchase Price (3,254,300)
Net Profit $4,783,300
Returnon Investment = Net Profit -X 100 Purchase Price
Returnon Investment = $4783300 00x100 $3254300
Returnon Investment = 147%
I hope this clear your doubt.
Feel free to comment if you still have any query or need something else. I'll help asap.
Do give Thumbs up if you find this helpful.
Less: Tax @15% ($1,418,400)
Effective sales Price $8,037,600
Less: Purchase Price (3,254,300)
Net Profit $4,783,300
Returnon Investment = Net Profit -X 100 Purchase Price
Returnon Investment = $4783300 00x100 $3254300
Returnon Investment = 147%
I hope this clear your doubt.
Feel free to comment if you still have any query or need something else. I'll help asap.
Do give Thumbs up if you find this helpful.
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