Question

- Understand the drawback of using the payback period to compare
projects?
- What are the basics of all components of capital?
- What are the cost of retained earnings and why they are not free?
- Why do we adjust the cost of debt?

Answer #1

Solution 1) Drawbacks of Payback period:

- Payback Period is not based upon the principle of the time value of money.
- Since it does not include the time value money effect, thus, it ignores the risk associated with the project.
- It does not include the cash flows that occur after the payback period. Example: Consider two projects A and B below:

Time | t=0 | t=1 |
t=2 |
t=3 | t=4 | t=5 |

Cash Flows (Project A) | -1000 | 300 | 200 | 500 | 500 | 600 |

Cash Flows (Project B) | -1000 | 0 | 0 | 0 | 0 | 10,000 |

As per the payback period method, Project A is preferred while Project B is more profitable.

- The payback period does not measure profitability. It is a measure of how quickly the invested amount is recovered back from the investment. Thus, it has to be used along with NPV or IRR method.

Solution 2: Any instrument through which a firm raises the financing is known as a component of capital. The components of capital are considered into two broader types:

- Equity
- Debt

**Debt:** It is referred to the source of capital
raised by borrowing. On this debt, the company pas interest along
with the principal repayment. This interest forms the cost of debt.
In this source of financing, there is no transfer of ownership and
the borrower is legally bounded to pay for the interest as well as
the principal repayment even in case of losses.

**Equity:** In equity financing, the capital is
raised by issuing the shares and transferring the ownership. Thus
in equity, capital is raised by selling the stakes and thus,
dilution of ownership takes place. In this case, the company is not
liable to repay the money. The equity shareholders receive the
return in the form of share appreciation and dividends. Dividends
are the shareholder's proportion in the company's profits.

Solution 3: Retained Earnings are the profits retained by the company and are not distributed to the shareholders in the form of dividends. The cost of retained earnings is defined as the cost incurred by the company for using the retained earnings. The cost of retained earnings is less as compared to the cost of issuing the new equity because no floatation cost is involved in raising the capital through the retained earnings.

While neither interest nor dividend is to be paid on retained earnings but still the retained earnings are not considered as free. This is because there are some opportunity costs that are associated with the retained earnings. If these retained earnings were not used, this would have to be paid to shareholders as dividends. Thus, the dividends could be used by shareholders to invest in other investments. hence, there is some opportunity cost associated with the retained earnings, hence, the cost of retained earnings is not free.

Solution 4: Let’s assume that a company pays $20,000 in interest for a given year. The $20,000 is an expense that the company is allowed to recognize before calculating the taxable income.

Let's Earnings before interest and tax (EBIT) = $100000

EBIT | 100000 |

Interest | 20000 |

Profit before tax | 80000 |

Tax Expense (Tax rate is 30%) | 24000 |

Net Income | 56000 |

Interest expense reduces the company’s profits before tax by $20,000, and assuming a 30% tax rate, reduces profits after tax by only $14,000. This is because interest expense provides a tax shield of $6,000.

Tax shield = Interest expense * tax rate ($20,000 x 30% = 6,000).

Adjusting for the interest tax shield, the real after-tax cost of debt for the company is not really $20,000, but only $14,000. Tax savings are only realized on payments to holders of debt instruments.

why can't we compare between projects that has different period
( years ) , using the present worth (PW) method or using future
worth (FW) method ? while its possible to use annual worth
comparison method ? what is it that makes annual worth method able
to do such comparisons?

1. What is the difference between payback period and discounted
payback period? Do you know any projects that used these two
capital budgeting techniques?

Payback period. What are the payback
periods of projects E and F? Assume all the cash flow is evenly
spread throughout the year. If the cutoff period is 3 years,
which project(s) do youaccept?
Cash Flow E F
Cost 36,000 95,000
Cash flow year 1 9,000 9,500
Cash flow year 2 9,000 19,000
Cash flow year 3 9,000 28,500
Cash flow year 4 9,000 38,000
Cash flow year 5 9,000 0
Cash flow year 6 9,000 0

1. What is the difference between payback period and discounted
payback period? Do you know any projects that used these two
capital budgeting techniques?
2. What are the reinvestment rate assumptions for NPV and
IRR?
3. The U.S. economy is contracting this year. What can corporate
capital spending signal to this issue?

11. The NPV and payback period
What information does the payback period provide?
A project’s payback period (PB) indicates the number of years
required for a project to recover its initial investment using its
operating cash flows. As the theoretical soundness of the
conventional (undiscounted) PB technique was criticized, the model
was modified to incorporate the time value of money-adjusted
operating cash flows to create the discounted payback method. While
both payback models continue to reflect faulty ranking criteria,
they...

7. The NPV and payback
period
What information does the payback period
provide?
Suppose Extensive Enterprises’s CFO is evaluating a project with
the following cash inflows. She does not know the project’s initial
cost; however, she does know that the project’s regular payback
period is 2.5 years.
Year
Cash Flow
Year 1
$325,000
Year 2
$500,000
Year 3
$450,000
Year 4
$450,000
If the project’s weighted average cost of capital (WACC) is 8%,
what is its NPV?
$367,583
$312,446
$404,341...

What information does the payback period provide?
Suppose Praxis Corporation’s CFO is evaluating a project with
the following cash inflows. She does not know the project’s initial
cost; however, she does know that the project’s regular payback
period is 2.5 years.
Year
Cash Flow
Year 1
$300,000
Year 2
$450,000
Year 3
$400,000
Year 4
$450,000
If the project’s weighted average cost of capital (WACC) is 10%,
what is its NPV?
A.) $302,510
B.) $332,761
C.) $317,636
D.) $287,385
Which...

Payback period.
Given the cash flow of two projectslong dash—A and Blong
dash—and using the payback period decision model, which
project(s) do you accept and which project(s) do you reject if you
have a 3-year cutoff period for recapturing the initial cash
outflow? For payback period calculations, assume that the cash
flow is equally distributed over the year.
Cash Flow
A
B
Cost
$14,000
$90,000
Cash flow year 1
$7,000
$36,000
Cash flow year 2
$7,000
$27,000
Cash flow...

3. Which one of the following is not a problem
of using the payback period?
Firm cutoffs are subjective.
Does not consider time value of money.
Does not consider any required rate of return.
Consider all of the project's cash flows.
None of the above are problems of using the payback
period.
4. A firm is starting a new project
that will cost $200,000. It is projected to last 5 years and to
generate cash flows of $50,000, $70,000, $90,000, $50,000...

The NPV and payback period
Suppose you are evaluating a project with the cash inflows shown
in the following table. Your boss has asked you to calculate the
project’s net present value (NPV). You don’t know the project’s
initial cost, but you do know the project’s regular, or
conventional, payback period is 2.50 years.
The project's annual cash flows are:
Year
Cash Flow
Year 1
$400,000
Year 2
600,000
Year 3
500,000
Year 4
475,000
If the project’s desired rate...

ADVERTISEMENT

Get Answers For Free

Most questions answered within 1 hours.

ADVERTISEMENT

asked 2 minutes ago

asked 13 minutes ago

asked 32 minutes ago

asked 32 minutes ago

asked 34 minutes ago

asked 40 minutes ago

asked 47 minutes ago

asked 52 minutes ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago