Twyman Exam 2, 1
Exam 2 Ashley V Twyman
Presented in partial fulfillment for Financial Analysis & Management 565 8/17/2009 – 9/27/2009 Dr. Joel Light
Twyman Exam 2, 2
1) From one point of view, inflation does not create a problem in the evaluation of a capital budgeting project. From another point of view, inflation creates tremendous problems in the evaluation of a capital budgeting project. What are these points of view? Which do you personally believe and why? Inflation can affect the required return of a project, which would mean that a required return, when considering inflation, would need to be higher than if inflation was not being included in calculations. We all know that if the required return is not met, the investment will not be profitable and the NPV of the company suffers because the actual cash flow of the project ends up being less than what was originally projected. Inflation can affect different components of a cash flow differently. For example, inflation may increase revenues 6% and cost of operation 12%. If these measurements are not included in calculations, you may end up with an end result that differs greatly than the projected result. Inflation may be over looked, at times, because it usually represents such small changes that some feel as though it is more of a cost to consider and deal with than inflation is in itself. I believe that inflation COULD create a tremendous problem, but not in every situation. In shorter term budgeting, inflation may not be a factor of extreme importance to consider; however, on longer term capital budgeting projects, it may be a key piece of the puzzle that needs to be considered and
Twyman Exam 2, 3 weighed in relation to suggested projects when considering the required return on each proposal. I do believe that inflation should usually be considered, even if it means a small difference. Over time, those small differences can add up to a large difference if the inflation rate is never adjusted for. For larger corporations who have much more money at stake, inflation should never be overlooked, especially in an uncertain economy. Smaller businesses may not be affected so greatly by inflation because they have a smaller NPV to begin with. 2) Why can the NPV and IRR methods disagree on the rankings for mutually exclusive projects? If they disagree, which method do you personally believe has more merit and why? The NPV is the current Net Present Value of a company. The IRR is the Internal Rate of Return. You should undertake a project only if the IRR exceeds the project’s capital cost. Usually the NPV and IRR seem to be presenting the same information and they frequently agree with each other. However, there are cases where they do not. The two values can disagree when dealing with mutually exclusive capital budgeting projects and non-conventional projects. When there are differences in project size and cash flow timing (when considering numerous projects at one time) the IRR and NPV can differ and usually the NPV decision rule will be used alone for the final decision. While using the NPV and IRR methods together can greatly increase your information
Twyman Exam 2, 4 base, I believe that the NPV method is more beneficial for many reasons. First of all, it is more universally used and is easier to understand and calculate. Of course with any calculation, your actual numbers may be different than your expected outcome, but it is a great way to estimate based on current facts. Bottom line is that the NPV decision rule trumps the IRR decision rule. 3) Suppose you are a manager considering a capital budgeting project. You have examined the proposed project and according to every relevant piece of information you can find, you feel this project should be undertaken. After submitting your analysis, the division head informs you that the project ahs not been approved for funding. Discuss the possible causes of the differences between your opinion and that of upper management. In this situation it is very possible that upper management has a broader view of the company and the surrounding external factors (such as other company current events) that could be impacting the decision to turn away the project I recommended. It could be that upper management is aware of other external issue in the surrounding business environment that could create some conflict for my proposed project to be completed. They may have also received other proposals which they found to be less costly with a larger rate of return than the project I saw fit to submit to them. There are many reasons why management may have denied my proposal. I don’t think it would be out of place for me to ask upper management to justify their decision, because there should be a valid reason why my proposal is thrown off the table. Asking for more
Twyman Exam 2, 5 information could also help me to determine when a better time to discuss my proposal would be in the future. If you believe that a project is worth something or adds some sort of value to your company, you should not give up on it because it may be turned down once. The reasons that management denies it could have nothing to do with your proposal or those reasons could tell you how you can make your proposal better for re-submission.