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Corporate Chap 1

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11 views3 pages

Corporate Chap 1

Uploaded by

Elaa Yaakoubi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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https://testbook.

com/question-answer/in-which-of-the-following-methods-of-capit
al-budge--63d950a1231485b846c2b

https://www.studocu.com/row/document/brock-university/corporate-finance-i/cha
pter-1-mcq-quiz/9235785

Net Present Value method:

● It is a method used to determine the current value of all future cash flows
generated by a project, including the initial capital investment. It is widely used in
capital budgeting to establish which projects are likely to turn the greatest profit.
● A project's net present value (hereafter NPV) is defined as the sum of the
discounted value of all receipts minus the sum of the discounted value of all
expenditures. All discounting is to the beginning of the project.
● The decision rule for NPV is to accept the project if the NPV is positive and reject
the project if the NPV is NPV is negative.

Internal rate of return (IRR) Method:

● It is a metric used in financial analysis to estimate the profitability of potential


investments. An IRR is a discount rate that makes the net present value (NPV) of
all cash flows equal to zero in a discounted cash flow analysis.
● If the IRR of a new project exceeds a company’s required rate of return, that
project will most likely be accepted. If IRR falls below the required rate of return,
the project should be rejected.

Ranking conflicts between NPV and IRR:

● For single and independent projects with conventional cash flows, there is no
conflict between NPV and IRR decision rules. However, for mutually exclusive
projects, the two criteria may give conflicting results.
● The NPV is a direct measure of the expected increase in the value of the
firm.
● The NPV assumes reinvestment of cash flows at the required rate of return
(more realistic), whereas the IRR assumes reinvestment of cash flows at the
IRR rate (less realistic).
● IRR is not useful for projects with non-conventional cash flows as such projects
can have multiple IRRs, i.e., there are more than one discount rate that will
produce an NPV equal to zero.
● Therefore, the reason for conflict is due to differences in cash flow patterns
and differences in project scale, i.e., investment size disparity and
investment life disparity.

​Hence, the correct answers are A, B and C only.

The correct answer is Net Present Value

Capital Budgeting:

● Capital Budgeting is the process of making financial decisions regarding


investing in long-term assets for a business.
● It involves conducting a thorough evaluation of risks and returns before
approving or rejecting a prospective investment decision.
● There are several capital budgeting analysis methods that can be used to
determine the economic feasibility of a capital investment.
● They include the Payback Period, Discounted Payment Period, Net Present
Value, Profitability dex, Internal Rate of Return, and Modified Internal Rate of
Return.

Key Points
Net Present Value (NPV):

● The Net Present Value (NPV) is a method that is primarily used for financial
analysis in determining the feasibility of investment in a project or a business.
● It is the present value of future cash flows compared with the initial investments.

Payback period:

● It refers to the time taken by a proposed project to generate enough income to


cover the initial investment.
● The project with the quickest payback is chosen by the company.

Internal Rate of Return:

● IRR refers to the method where the NPV is zero.


● In such as condition, the cash inflow rate equals the cash outflow rate.
● Although it considers the time value of money, it is one of the complicated
methods.
● As with the Net Present Value analysis, the Internal Rate of Return can be
compared to a Threshold Rate of Return to determine if the investment should
move forward.
● Under this method, cash flows are reinvested at the cost of capital.
● It follows the rule that if the IRR is more than the average cost of the capital, then
the company accepts the project, or else it rejects the project.

Accounting rate of return (ARR):

● The ARR formula divides an asset's average revenue by the company's initial
investment to derive the ratio or return that one may expect over the lifetime of
an asset or project.
● ARR does not consider the time value of money or cash flows, which can be an
integral part of maintaining a business.

Hence, In the Net Present Value method, cash flows are reinvested at the cost of
capital.

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