FIN 320F Unit 11, 12 & 13 exam with complete solutions 2024_2025
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Course
FIN 320F
Institution
FIN 320F
Describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule?
PV is the sum of the present values of a project's cash flows. It's a way of doing cost-benefit analysis.For most projects their cash flows occ...
FIN 320F Unit 11, 12 & 13 exam with
complete solutions 2024/2025
Describe how NPV is calculated and describe the information this measure
provides about a sequence of cash flows. What is the NPV criterion decision
rule? - ANSWER- PV is the sum of the present values of a project's cash flows.
It's a way of doing cost-benefit analysis.For most projects their cash flows occur
at different points in time. A valid comparison is possible only if these cash flows
can be restated as of a single point in time. This involves using the opportunity
cost, which reflects the basic time value of money (risk free interest rate) and an
appropriate risk premium. Again drawing on the concept of cost-benefit analysis,
NPV measures whether or not the project increases wealth. Wealth is command
over economic assets. Wealth is increased if cash inflows stated as of today
exceed the cash outflows also stated as of today: the cash available—wealth—
has increased.NPV takes into account all aspects of economic value: cash flows,
the timing of these cash flows, and the risk-adjusted opportunity cost. The NPV
decision rule is to accept projects that have a positive NPV, and reject projects
with a negative NPV.
Why is NPV considered to be a superior method of evaluating the cash flows from
a project? Suppose the NPV for a project's cash flows is computed to be $2,500.
What does this number represent with respect to the firm's shareholders? -
ANSWER- NPV desirability: NPV is superior to the other methods of analysis
presented in our course because it directly measures a decision's impact on
wealth. The only drawback to NPV is that it relies on cash flow and discount rate
values that are often estimates and not certain, but this is a problem shared by
the other performance criteria as well. A project with NPV = $2,500 implies that
the total shareholder wealth of the firm will increase by $2,500 if the project is
accepted. This does not mean the shareholders get a check for that amount: it is
a statement of the expected increase in wealth given the project, which should be
reflected by an increase in the stock price.
Describe how the IRR is calculated, and describe the information this measure
provides about a sequence of cash flows. What is the IRR criterion decision rule?
, - ANSWER- The IRR is the rate of return earned on an investment. It is the
discount rate that causes the NPV of a series of cash flows to be equal to zero.
IRR can thus be interpreted as a financial break-even rate of return; at the IRR
discount rate, the net value of the project is zero. For investments, the IRR
decision rule is to accept projects with IRRs greater than the opportunity cost.
For example, if a project has an IRR = 12%, and projects of equivalent risk earn a
return of 8%, then the project is earning above what would be expected of a
similar project and should be accepts. Projects earning less than the opportunity
cost should be rejected. If the opportunity cost is 8%, but a project's IRR = 6%,
then the project should be rejected, as the investor should be able to obtain a
project earning 8%.
What is the relationship between IRR and NPV? Are there any situations in which
you might prefer one method over the other? Explain. - ANSWER- RR is the
interest rate that a project earns, whereas the required rate of return is the
opportunity cost of the project: the rate of return the project should earn given its
risk. NPV directly uses the opportunity cost to evaluate the project's cash flows,
and is thus is preferred in all situations to IRR. For stand-alone projects with
conventional cash flows, IRR and NPV are interchangeable techniques; however,
IRR can lead to ambiguous results if there are non-conventional cash flows, and
also ambiguously ranks some mutually exclusive projects.
Despite its shortcomings in some situations, why do most financial managers
use IRR along with NPV when evaluating projects? Can you think of a situation in
which IRR might be a more appropriate measure to use than NPV? Explain. -
ANSWER- IRR is frequently used because it is easier for many financial managers
and analysts to rate performance in relative terms, such as "12%", than in
absolute terms, such as "$46,000."IRR may be a preferred method to NPV in
situations where an appropriate discount rate is unknown or uncertain; in this
situation, IRR might provide more information about the project than would NPV.
Describe how the profitability index is calculated and describe the information
this measure provides about a sequence of cash flows. What is the profitability
index decision rule? - ANSWER- The profitability index is the present value of the
future cash flows, discounted by the opportunity cost, divided by the initial
investment. It measures the wealth created per dollar invested, providing a
measure of the relative profitability of a project.The profitability index decision
rule is to accept projects with a PI greater than one, and to reject projects with a
PI less than one. A PI greater than one indicates that the project will return more
than a dollar for each dollar invested, with this comparison using proper time
value analysis
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