M1A2 Discussion

Peer 1

M1A2: Capital-Budgeting Criteria

Jiaying Wang posted Mar 16, 2018 4:58 PM

What is the logic behind the NPV capital-budgeting framework?

Net present value is a capital budgeting method that may be the most accurate capital budgeting method used by business owners to evaluate whether to invest or not invest in new capital projects. According to Alan C. Shapiro stated, in order to meet the goal of maximizing shareholder wealth, the value of potential investment projects must meet three criteria: • It must focus on cash and only cash. • It must account for the time value of money. • It must account for risks. The only value that is consistent with these criteria is the net present value of the project - the present value of the project's future cash flow minus the cost of the project (pg.14).

Would changes in the cost of capital ever cause a change in the IRR ranking of several projects?

Changes in capital costs have no effect on the ranking. Because net present value is calculated based on cash flow discounts, the higher the cost of capital the smaller the impact of long-term cash flow, and the lower the cost of capital, the greater the contribution of long-term cash flow. Due to the high cost of capital, short-term investments may be better than long-term investments, and vice versa. The internal rate of return (IRR) is the discount rate that sets the present value of the project cash flows equal to the initial investment outlay. In other words, the IRR is the discount rate that equates the project NPV to zero (Alan, pg.21).

When it is clear that a project will be profitable, why should it be rejected if it has a negative net present value?

If the NPV of a project is positive and greater than zero, then the NPV rule represents the continuation of the project because the investment should provide the company with a net gain in profitability and value. However, if present value of cash inflow is less than present value of cash outflow, the net present value is said to be negative and the investment proposal is rejected.

Why should cash flow to be received at the end of six years be discounted more heavily than cash flow to be received at the end of five years?

The time value of money. The timing of cash flows is of critical importance because of the opportunity cost of money. The longer the actual cash flow event takes place, the lower the present value of the future currency will be than its future value. Discounted cash flow (DCF) is an application of the time value of money concept - the value of money received or paid at a certain time today is lower than the equivalent amount actually received or paid today (Alan, pg.19).

References: Alan C. Shapiro, pg.14-21, (2018). Capital Budgeting and Investment Analysis. Received from: https://digitalbookshelf.argosy.edu/#/books/0558302580/cfi/6/16!/4/16/6/16/

Peer 2

GreerC-M1_A2_Capital Budgeting Criteria

Courtney Greer posted Mar 15, 2018 10:13 PM

Net Present Value is a capital budgeting method that compares the costs and benefits of proposed investments or projects. Net present value is used to primarily used to identify the most viable investment opportunities by comparing the present value of the future cash flows of projects. The logic for the net present value method is that it focuses on the maximization of the wealth for business owners or shareholders. (Cole-Ingait)

Changes in the cost of capital has no effect on IRR ranking. Therefore, the cost of capital should never cause a change in the IRR ranking of the projects.

The reason a project should be rejected because of a negative net present value is because the investment will decrease that value of the firm and because the return is less than the required return.

Cash flow that is discounted six years beyond the reach is discounted more heavily than that of cash to be received in five years is because it is worth less due to the delay in the reinvestment abilities. This is a concept of time value of money. Which means the money received or paid at some time in the future has less value today than an equal amount that was actually received or paid today. (Solution Matrix Ltd, 2018)

References:

Paul Cole-Ingait (Unknown) What is the Rationale Behind the Net Present Value Methods? Retrieved from http://smallbusiness.chron.com/rationale-behind-net-present-value-method-76800.html

Solution Matrix Ltd (3-14-2018) Discounted Cash Flow, Net present value, Time value of money Retrieved from https://www.business-case-analysis.com/discounted-cash-flow.html

Alan C. Shapiro (Unknown) Capital Budgeting and Investment Analysis Retrieved from https://digitalbookshelf.argosy.edu/#/books/0558302580/cfi/6/14!/4/2@0:0