The Relationship Between Finance and Investment - Essay Example

Question A A. PV = 10,500 15) 20 = 10,500 15) 20 = 10,500 16.37 = $ 641.42 B. Year Present Value (in US dollars 6,003.41 2 3,431.37 3 1,962.62 4 1,121.79 5 641.42 The illustration shows that the present value decreases as time progresses. The decline of the value is higher considering the principal amount. When the first payment is made on the third year instead on the fifth year, the value is higher with a difference of $ 1,321.2. C. Year Present Value (in US dollars) 1 9,130.43 2 7,939.51 3 6,903.92 4 6,003.41 5 5,223.88 When the opportunity cost is compounded annually, the values appear to b higher. It is evident that the annual payment provides better returns because the difference in values is far greater when compared to the value wherein the payment was made quarterly. Question 2 Year Project A Project B 0 -952,380.95 -952,380.95 1 500,000 523,651.79 2 775,623.27 1,066,666. 67 3 935,672.51 2,548,930.36 4 1,185,185.19 6,400,000 NPV 4,348861.92 8,942,669.41 Based on the given information, it appears that all projects are viable because of the positive NPV. In selecting the best project, the highest NPV has to be considered. In this situation, Project B is expected to provide more gains. Its NVP is more than double compared to the NPV of Project A. This means that benefits generated by Project B are twice greater than Project A. In practice, there are several aspects that can affect the determination of the coefficients. First, the inflation rate is one of the indicators used to identify the coefficient. Basically, considering the inflation rate changes the value of the principal as time progresses. Usually, the interest rate changes the amount that is expected to be gained from an investment when the benefits of the venture are realized in an installment basis. Second, the interest rates are also valuable aspects in determining of the coefficient. This happens when the project is financed by debt. It is imperative that the interest rate will serve as factor. Question 3 A. Usually, senior executives view the different valuation methods to be similar. The most extensively used among the schemes is the Discounted Cash Flow (DCF) because of its inclination to be flexible and accurate. Some instances, however, suggests that several aspects affect the precision of the forecasts. Benchmarking the methods used by the company to its competitors is a viable scheme to arrive at more accurate predictions. The process when correctly manifested enables the company to determine mismatches in performance and strategically determine its position in the industry. Using multiples analysis provides insights that contribute in creating value in the industry. Multiples analysis is often miscomprehended and misused. Several analysts have failed to consider minor details that have great impact on the end result. Given this limitation, the companies can address the deficiency through meticulous designing of the multiples analysis. A prominent design was developed by Credit Suisse First Boston (CSFB) which tracks the stock movements among US firms. Another important problem observed in multiples analysis is that the method results to several varying conclusions. Overall, multiples analysis remains as an important component of DCF which accurately determines the future gains of investments. B. One of the main uses of multiples analysis is on predicting the price of stock markets. It assumes that the same prospects apply to the firm being studied. This appears to be limited because such has never been the situation for some firms. Using the same prospect makes the forecasting limited. In effect, it will difficult to arrive at an accurate result. In addition, it has been detected that the method tends to provide unexpected difference. In forecasting, the analyst draws conclusions that will like be observed. Multiples analysis becomes problematic because analysts fail to recognize the important differences after the results have been obtained. Amidst the use of multiples in DCF, its inevitable threat when used inappropriately will negatively affect the performance of the company including the future expectations. Question 4 Rate of Return = Next Dividend / Stock Price + Growth = 3.22 / 32.84 + .095 = 3.22 / 32.94 = 9.8 % In this computation, the Gordon growth Formula was used. It assumes that the company grows at a constant rate as time progresses. From this assumption alone, it is clear that there is a slim possibility of accurateness. First, firms have unpredictable growth and even experience losses. It is hard to fathom a company that provides a consistent growth rate given the market uncertainties. Second, firms usually work towards attaining high growth. This inclination is totally in contrary to assumption used because the growth rate needs to change. Question 5 A. The IRR of the project is 26.06 % B. The purpose of computing the IRR is to determine whether an investment will be profitable during a period of time as being implemented. Basically, the most important indicator that the IRR is acceptable is if it equals or exceeds the cost. In normal practices, however, it is always preferred that the IRR is greater than the cost. The IRR is the rate of interest earned on the funds invested in the project and if the IRR exceeds the cost of those funds the investment is clearly acceptable. Analysts find a high IRR more significant determinant of an investment's quality than a large NPV as the latter is a function of scale as well as profitability. Question 6 A. The determination of capital cost is highly dependent of the kind of project being carried out. Generally, the cost of capital can be grouped into tangible and intangible. The tangible costs comprise most of the information needed to determine actual capital cost. Basically, the tangible costs represent the expenditures on aspects that are noticeable and serve as the physical foundation of the project. For instance, one of the tangible capital costs needed for constructing buildings is steel. Aside from the tangible costs, there are some expenses that are only felt. One example is the permit that the investor acquires. Permits are assurance that the projects are undertaken without legal impediments and other concerns. B. Indeed, there are several considerations needed to be made when reporting the cost of capital in the balance sheet. First, the valuation of the cost is an important aspect that needs to be discussed. Normally, firms use either the historical cost or the fair market value of the cost. The method of valuation used by the company affects the cost as reflected in the balance sheet. Second, the depreciation method used for the asset also affects the cost. It is imperative that financial analysts find a suitable depreciation scheme for the varying costs. Finally, the amortization of intangible costs is also an important subject to consider. Holistically, costs have to be determined using schemes that are proven to be accurate and flexible. Question 7 A. It was mentioned that the machines were mutually exclusive for the project. This means that the machines are solely devoted for the project. Using the machines outside the project is definitely out of the equation. In the manner, both machines are interchangeable. At some point, Machine A can substitute Machine B and it goes the same was with Machine B. Therefore, it is important for the company to determine the machine that provides the best return. B. Particulars Machine A Machine B Initial Investment -30,000 -45,000 Cash Flow (Year 1) 22,000 22,000 Cash Flow (Year 2) 22,000 22,000 Cash Flow (Year 3) 22,000 22,000 Cash Flow (Year 4) 22,000 22,000 Cash Flow (Year 5) 22,000 22,000 Cash Flow (Year 6) 22,000 Cash Flow (Year 7) 22,000 Cash Flow (Year 8 22,000 Cash Flow (Year 9) 22,000 Cash Flow (Year 10 22,000 Salvage Value 4,000 Operating Cost -10,000 -8,000 IRR 54.08% 50.89% C. Based on the calculated NPV it appears that the two machines can be compared. This is based on the assumption that the cash flow continues to be equal and the values used for the computation are uniformly determined. D. Based on the IRR of both machines, it is definitely logical to purchase Machine A. On the other hand, using the NPV provides a different interpretation. For one, the cash flow of Machine B extends until 10 years. Although the value of the cash flow diminishes, its contribution to the overall benefits is hard to ignore. Definitely, Machine B is the best optioned based on its higher NPV. References Multiples Analyses. Date retrieved: 21 November 2006, from: http://ocw.mit.edu/NR/rdonlyres/Sloan-School-of-Management/15-535Business-Analysis-Using-Financial-StatementsSpring2003/E3D09F4A-B369-4EAF-A146-0B6542B45318/0/class5.pdf The McKinsey Quarterly. " The right roles for multiples in valuation." Date retrieved: 21 November 2006, from: http://www.mckinseyquarterly.com/article_abstract_visitor.aspxar=1587 Expected Rate of Return. Date retrieved: 21 November 2006, from: http://answers.google.com/answers/threadviewid=574311 Handbook of IQP Advisors and Teachers. "Investment decisions - Life cycle costing." Date retrieved: 21 November 2006, from: http://www.wpi.edu/Academics/Depts/IGSD/IQPHbook/ch12c.html Cost of Capital Components. Date retrieved: 21 November 2006, from: http://www.fao.org/docrep/005/Y3780E/y3780e05.htm Read More