Page 208 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Risk-free Rate: The rate at which the future cash flows of a project which is not subjected to risk
are discounted.
Risky Investment: Risk in an investment refers to the variability that is likely to occur between
the estimated returns and the actual returns.

9.11 Review Questions
1. Why is capital budgeting significant to the firm?

2. How should working capital and sunk costs be treated in analyzing investment
opportunities? Explain with suitable examples.
3. Depreciation is a non-cash item and consequently does not affect the analysis of investment
proposal using discounted cash flow method? Comment.
4. Contrast the IRR and the NPV methods. Under what circumstances may they lead to
(a) Comparable recommendation
(b) Conflicting recommendation in circumstances in which they given contradictory
results which criteria should be used to select the project and why?
5. A project costing 5,60,000 is expected to produce annual net cash benefits of 80,000 over
a period of 15 years. Estimate the internal rate of return. Also find out the payback period
and obtain the IRR from it. How do you compare this IRR with one directly estimate?
6. How is risk assessed for a particular investment by using a probability distribution?
Discuss the method with an example.
7. Why are cash flows estimated for distant years usually less reliable than for recent years?
How can this factor be considered when evaluating the riskiness of a project?
8. What similarities and differences are there between risk adjusted discount rate method
and the certainty equivalent method?
9. What is sensitivity analysis? What are its advantages and limitations?
10. KC company is considering two mutually exclusive projects. The initial cost of both
projects is 5000 and each has an expected life of four years. Under three possible states of
economy, their annual cash flows and associated probabilities are as follows:

Net Cash flow ( )
Economic state Probability Project A Project B
Good 0.3 6000 5000
Normal 0.4 4000 4000
Bad 0.3 2000 3000

Answers: Self Assessment
1. Capital budgeting 2. reversible 3. two-sided
4. incidental 5. minimum 6. Profitability index
7. Internal rate of return 8. negative 9. capital rationing
10. zero 11. capital investment 12. risk

13. variability 14. short 15. discount rate
16. decision tree 17. Sensitivity 18. standard deviation

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