TwymanExam 2, 1

Exam 2

Ashley V Twyman

Presented in partial fulfillment for

Financial Analysis & Management 565

8/17/2009 – 9/27/2009

Dr. Joel Light

TwymanExam 2, 2

1) From one point of view, inflation does not create a problem in the evaluation of

a capital budgeting project. From another point of view, inflation creates

tremendous problems in the evaluation of a capital budgeting project. What are

these points of view? Which do you personally believe and why?

Inflation can affect the required return of a project, which would mean that

a required return, when considering inflation, would need to be higher than if

inflation was not being included in calculations. We all know that if the required

return is not met, the investment will not be profitable and the NPV of the

company suffers because the actual cash flow of the project ends up being less

than what was originally projected.

Inflation can affect different components of a cash flow differently. For

example, inflation may increase revenues 6% and cost of operation 12%. If these

measurements are not included in calculations, you may end up with an end

result that differs greatly than the projected result. Inflation may be over looked,

at times, because it usually represents such small changes that some feel as

though it is more of a cost to consider and deal with than inflation is in itself.

I believe that inflation COULD create a tremendous problem, but not in

every situation. In shorter term budgeting, inflation may not be a factor of

extreme importance to consider; however, on longer term capital budgeting

projects, it may be a key piece of the puzzle that needs to be considered and

TwymanExam 2, 3

weighed in relation to suggested projects when considering the required return

on each proposal.

I do believe that inflation should usually be considered, even if it means a

small difference. Over time, those small differences can add up to a large

difference if the inflation rate is never adjusted for. For larger corporations who

have much more money at stake, inflation should never be overlooked,

especially in an uncertain economy. Smaller businesses may not be affected so

greatly by inflation because they have a smaller NPV to begin with.

2) Why can the NPV and IRR methods disagree on the rankings for mutually

exclusive projects? If they disagree, which method do you personally believe has

more merit and why?

The NPV is the current Net Present Value of a company. The IRR is the

Internal Rate of Return. You should undertake a project only if the IRR exceeds

the project’s capital cost. Usually the NPV and IRR seem to be presenting the

same information and they frequently agree with each other. However, there are

cases where they do not. The two values can disagree when dealing with

mutually exclusive capital budgeting projects and non-conventional projects.

When there are differences in project size and cash flow timing (when

considering numerous projects at one time) the IRR and NPV can differ and

usually the NPV decision rule will be used alone for the final decision. While

using the NPV and IRR methods together can greatly increase your information

TwymanExam 2, 4

base, I believe that the NPV method is more beneficial for many reasons. First of

all, it is more universally used and is easier to understand and calculate. Of

course with any calculation, your actual numbers may be different than your

expected outcome, but it is a great way to estimate based on current facts.

Bottom line is that the NPV decision rule trumps the IRR decision rule.

3) Suppose you are a manager considering a capital budgeting project. You have

examined the proposed project and according to every relevant piece of

information you can find, you feel this project should be undertaken. After

submitting your analysis, the division head informs you that the project ahs not

been approved for funding. Discuss the possible causes of the differences

between your opinion and that of upper management.

In this situation it is very possible that upper management has a broader

view of the company and the surrounding external factors (such as other

company current events) that could be impacting the decision to turn away the

project I recommended. It could be that upper management is aware of other

external issue in the surrounding business environment that could create some

conflict for my proposed project to be completed. They may have also received

other proposals which they found to be less costly with a larger rate of return

than the project I saw fit to submit to them. There are many reasons why

management may have denied my proposal. I don’t think it would be out of place

for me to ask upper management to justify their decision, because there should

be a valid reason why my proposal is thrown off the table. Asking for more

TwymanExam 2, 5

information could also help me to determine when a better time to discuss my

proposal would be in the future. If you believe that a project is worth something or

adds some sort of value to your company, you should not give up on it because it

may be turned down once. The reasons that management denies it could have

nothing to do with your proposal or those reasons could tell you how you can

make your proposal better for re-submission.