# the project profitability index and the internal rate of return

In case of project having value of profitability index equal to one then its net present value would be zero. IRR represent internal rate of return.

114. Explain how the internal rate of return (IRR) decision rule is applied to projects with financing cash flow

Financing projects are decided by analyzing IRR with required rate of return. In case of project having higher required return than internal rate of return (IRR), project is accepted. In case of lower required rate of return than internal rate of return (IRR), project is rejected.

115. Explain the differences and similarities between net present value (NPV) and the profitability index.

For analysis time value of money, both these above-mentioned methods are used. Both net present value and profitability index is used for decision-making of investing in project. In case of limited availability of funds, profitability index is preferred. In case of mutually exclusive projects, profitability index does not provide more accurate results.

116. How does the net present value (NPV) decision rule relate to the primary goal of financial management, which is creating wealth for shareholders?

Net present value is used for accepting or rejecting projects. Projects are accepted in case of positive net present value. It is related with wealth creation because projects are only accepted when they create wealth that is basic goal of financial management. Shareholder’s wealth is not destroyed in case of projects having net present value equal to zero.

103. In a single sentence, explain how you can determine which cash flows should be included in the analysis of a project.

By making project’s analysis, it also analyzed that what change is occurring in cash flow due to acceptance of that project. It should be included in analysis.

104. What is the formula for the tax-shield approach to OCF? Explain the two key points the formula illustrates.

Formula = (Sales - Costs) × (1 - T) + Depreciation × T

Operating cash flow is affected by expenses and cash income. It is also affected by depreciation. Depreciation results in saving of tax so it has effect on operating cash flow.

105. What is the primary purpose of computing the equivalent annual costs when comparing two machines? What is the assumption that is being made about each machine?

Each machine’s annual cost is computed for identifying that which machine is least expensive. Different machines have different cost and life. Assumption behind this computation is that after the end of useful life of machine, it will be replaced with new one.

106. Assume a firm sets its bid price for a project at the minimum level as computed using the discounted cash flow method. Given this, what do you know about the net present value and the internal rate of return on the project as bid?

Assumption that is made in identifying bid price of project by discounted cash flow method is that the project will have net present value equal to zero. It means that it should have IRR equivalent to required rate of return.

Assignment on Questions and answers By: ABC Date 113.The profitability index (PI) of a project is 1.0. What do you know about the project's net present value (NPV) and its internal rate of return (IRR)? In case of project having value of profitability index equal to one then its net present value would be zero. IRR represent internal rate of return. 114. Explain how the internal rate of return (IRR) decision rule is applied to projects with financing cash flow Financing projects are decided by analyzing IRR with required rate of return. In case of project having higher required return than internal rate of return (IRR), project is accepted. In case of lower required rate of return than internal rate of return (IRR), project is rejected. 115. Explain the differences and similarities between net present value (NPV) and the profitability index. For analysis time value of money, both these above-mentioned methods are used. Both net present value and profitability index is used for decision-making of investing in project. In case of limited availability of funds, profitability index is preferred. In case of mutually exclusive projects, profitability index does not provide more accurate results. 116. How does the net present value (NPV) decision rule relate to the primary goal of financial management, which is creating wealth for shareholders? Net present value is used for accepting or rejecting projects. Projects are accepted in case of positive net present value. It is related with wealth creation because projects are only accepted when they create wealth that is basic goal of financial management. Shareholder’s wealth is not destroyed in case of projects having net present value equal to zero. 103. In a single sentence, explain how you can determine which cash flows should be included in the analysis of a project. By making project’s analysis, it also analyzed that what change is occurring in cash flow due to acceptance of that project. It should be included in analysis. 104. What is the formula for the tax-shield approach to OCF? Explain the two key points the formula illustrates. Formula = (Sales - Costs) × (1 - T) + Depreciation × T Operating cash flow is affected by expenses and cash income. It is also affected by depreciation. Depreciation results in saving of tax so it has effect on operating cash flow. 105. What is the primary purpose of computing the equivalent annual costs when comparing two machines? What is the assumption that is being made about each machine? Each machine’s annual cost is computed for identifying that which machine is least expensive. Different machines have different cost and life. Assumption behind this computation is that after the end of useful life of machine, it will be replaced with new one. 106. Assume a firm sets its bid price for a project at the minimum level as computed using the discounted cash flow method. Given this, what do you know about the net present value and the internal rate of return on the project as bid? Assumption that is made in identifying bid price of project by discounted cash flow method is that the project will have net present value equal to zero. It means that it should have IRR equivalent to required rate of return. 107. Can the initial cash flow at time zero for a project ever be a positive value? If yes, give an example. If no, explain why not. It will be positive in case of project if its net working capacity reduced. Initial cost of this project should be less than this reduction amount of capacity. 108. How can two firms arrive at two different bid prices when bidding for the same job and given the same bid specifications? Bidding price is different for each firm because of different assumptions. This assumption vary as per life of project, cost of material, labor cost, tax rates and required rate of return. Essay questions 102. What is operating leverage and why is it important in the analysis of capital expenditure projects? It tells reliance of project on fixed cost. In case of capital-intensive project, operating leverage will be higher. In case of higher operating leverage, change in quantity of sales have higher effect on change of operating cash flow. Work of leverages remain good until sales increases. In case of reduction in sales, it reduced operating cash flow. Risk forecasting is required more in these capital-intensive industries. 103. What is forecasting risk and why is it important to the analysis of capital expenditure projects? What methods can be used to reduce this risk? Incorrect decisions will be made in case of error in calculation of projected cash flow. In case of over estimation of cash flows may be a project that would have negative net present value would now have positive value. This leads to wrong decisions. In case of underestimation project would be rejected in fault. 104. What are the key features of the accounting, cash, and financial break-even points? In accounting break even, net income=0, payback period=life of project, IRR= 0, Operating cash is equal to depreciation. In Cash break even, operating cash flow is equal to zero, payback period is not taken, IRR is assumed as 100%, net present value is negative and operating cash flow is zero. In financial break even, net present value of project is zero, project life is equal to discounted payback period and IRR is taken as required return. 105. Assume that a country experiences a financial crisis that causes the nation's financial markets to freeze in a manner that prevents a private firm from raising capital from any source. Explain how project analysis conducted by that firm would work in this situation. It is called hard rationing. In this situation, a firm can obtain capital financing only by offering rate of return. In case of making decision of projects that are related with external finance, normal method for analysis of project would not be used. 106. Mr. Bear, your boss, will only agree to accept a project that, as a minimum, provides a rate of return equal to the requirement he has set for the project. Given this, explain how you can use break-even analysis to ascertain which projects will be acceptable to him as you don't want to risk hearing him growl if you waste his time presenting him with a project that is unacceptable Quantity of sales that is required for producing IRR equivalent to required rate of return is called quantity of financial break even. After establishment of quantity and justification of computable quantities, justification of sales should also be provided.