CLA 1 Paper - Financial Management

Part a

Payback period is defined as the time utilized to develop revenue so that it can cover all initial investment for a project (Ross et al., 2018). For example, the initial cost for starting an art studio includes rental, materials, labor and marketing, in total $100,000. The owner possibly earn $40,000 in the first year and $60,000 the next year. The payback period will be 2 years. There are disadvantages because time value of money is not considered, random cut-off will cause inaccuracy, cash flow beyond cut-off date will be ignored and long-term projects would be discriminated under the rule(Ross et al., 2018). Although there is discounted payback period rule can be implemented, it still lead to many disadvantges except for consideration of time value of the money. 

Internal rate of return represents the annual revenue return ratio where net present value equals to zero. It can be computed using the formula below. 

For example, a project will last one year. The initial investment C0 is $1,000,000, first year cash flow C1 is $1,100,000. It can be concluded that IRR should be 10% and NPV will be zero. Therefore, any required return lower than 10% can be accepted as profitable project. 

Modified internal rate of return would take multiple periods of cash flows and interest of cash flows at the same time. It requires future value calculation based on each year of cash flows and then compute the present value of all cash flows backwards. It can be applied to unconventional cash flows. 

Net present value is metric of difference between a project’s investment value and its initial cost. When NPV is positive, the project/investment is worthwhile to implement and therefore can be accepted. Otherwise, negative NPV normally means rejection. However, in real life business, it is not the only scale, such as long-term research and development or some new technology production projects (Ross et al., 2018). For instance, there is one project which has initial cost of $500,000 and has first year of $300,000 and the second year $300,000. The return ratio is 5% so present value for cash flows is $557,823. This means NPV equals to $57,823 and it is applicable to invest in this project. 

Profitability index is another metric highly related with NPV. It is calculated as investment value divided by initial cost. When profitability index is over 1, which means NPV is greater than zero, the project can be accepted accordingly. In the above mentioned example, PI=1.1156, indicating that it it acceptable to invest in the project. 

Part b

Conventional cash flows represents a series of cash flows, typically with one outward investment and then all inward cash flows. Conventional cash flows normally are composed of one directional cash flows. Unconventional cash flows represents a series of cash flows but contains different directions of cash flows. For example, typical conventional cash flows will be -$1 million, $0.2 million in the first year and $0.7 million in the second year. An unconventional cash flows could be -$1 million, $0.2 million in the first year, -$0.5 million in the third year and $0.7 million in the third year. 

For unconventional cash flows, IRR can be utilized to evaluate the cash flows but odd outcome would show up, such as multiple return of ratio, which does not necessarily give out an accurate answer of IRR. However, NPV would always work perfectly fine with investigating in breakeven point between investment cost and cash flows. 

A Fictitious Unconventional Cash Flow Example

The project with 15% required return ratio has initial investment of $610,000, the first year inward cash flow is $1,590,000 and the second year is negative inflow -$1,020,000. By calculating all evaluation criteria, the results are shown below. It indicates different evaluation results accordingly. Based on NPV, the project can be accepted because it has positive NPV. However, IRR 14% is lower than required return ratio. Thus the project cannot be accepted. MIRR is 15% equaling required return ratio and PI 1.0022 is over 1, so project can be successful. 

To investigate more, based on the unconventional cash flows, there are multiple crossing on NPV values, which causing inconsistent evaluation results(Shull, 1992), shown in the table and graph below. NPV has changed from negative, positive and back to negative. Therefore, for unconventional cash flows, IRR cannot be a trustworthy evaluation criteria. 

References

Ross, S. A., Westerfield, R. W., & Jordan, R. D. (2018). Fundamentals of corporate finance (12th ed.). McGraw-Hill

Shull, D. M. (1992). Efficient capital project selection through a yield-based capital budgeting technique. The Engineering Economist, 38(1), 1. Retrieved from https://www.proquest.com/scholarly-journals/efficient-capital-project-selection-through-yield/docview/206728110/se-2?accountid=158986