WEEK 2
TUTORIAL SOLUTIONS
1. What is meant by a project’s NPV and what is the decision rule. List the main
strengths and weaknesses of the NPV method.
NPV is simply the present value of a project’s cash flows, which
measures, after considering the time value of money, the net increase or
decrease in firm wealth due to the project. The decision rule is to accept
projects that have a positive NPV and reject projects with a negative
NPV. The main strengths of NPV are that it a) takes into account the time
value of money, b) incorporates scale in the estimate, and c) considers all
cash flows. NPV also has the value additivity property and uses actual
cash flows instead of accounting figures. The main weakness of NPV is
that it requires the estimation of a discount rate and cash flows, which are
often uncertain (although other performance criteria suffer from this
problem as well) In addition, it provides a point estimate of the value of
an investment, instead of a confidence interval.
2. What is a project’s payback period? Discuss the advantage and disadvantage of
the payback period.
Payback period is simply the accounting break-even point of a series of
cash flows. To actually compute the payback period, it is assumed that
any cash flow occurring during a given period is realized continuously
throughout the period, and not at a single point in time. The payback is
then the point in time for the series of cash flows when the initial cash
outlays are fully recovered. Given some predetermined cut-off for the
payback period, the decision rule is to accept projects that pay back
before this cut-off and reject projects that take longer to pay back. The
worst problem associated with the payback period is that it ignores the
time value of money. In addition, the selection of a hurdle point for the
payback period is an arbitrary exercise that lacks any steadfast rule or
method. The payback period is biased towards short-term projects; it fully
ignores any cash flows that occur after the cut-off point. The main
strength of payback period is its simplicity.
3. Review the main problems that arise when one uses only IRR to evaluate
potential projects.
There are several issues the analyst must consider when using IRR to
value investments. First, they must consider whether a collection of
candidate projects are mutually exclusive and/or independent. It is not
possible to compare projects if the scale of their investments are different
because a small scale project may have a high IRR but actually increase
wealth by very little in absolute terms. One must also be careful when
using IRR for projects that require investment or borrowing. If the cash
flows from the project change sign more than once, then it is very likely
that the project will have more than one IRR value. In spite of these
pitfalls, many managers use IRR over NPV because it provides a return in
relative as opposed to absolute terms. This may be particularly beneficial
when there is uncertainty over the appropriate discount rate.
4. Why do you think companies have issued bonds in different currencies,
maturities and coupon rates? Shouldn’t the coupon be the same on every bond?
Explain.
Bonds have different characteristics because of different risk. In addition,
companies may wish to issue a bond overseas in a different currency
because the appetite for purchasing the bond is greater overseas.
5. What is meant by hierarchies in long-term financing, and why are bonds higher
in priority than shares?
Hierarchies exist in long-term financing because it is necessary to ensure
that debt holders have first claim over the assets of a distressed firm.
Given that firms have several debt issues; these have to be prioritized in
terms of seniority.