FM ASSIGNMENT CYCLE TWO

(CLUSTER 4)

Q1. Rate at which present value of cash inflows and cash outflows is IRR?

ANS

What Is Internal Rate of Return (IRR)?

The internal rate of return (IRR) is a metric used in financial analysis to estimate
the profitability of potential investments. IRR is a discount rate that makes the net
present value (NPV) of all cash flows equal to zero in a discounted cash flow
analysis.

IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is
not the actual dollar value of the project. It is the annual return that makes the NPV
equal to zero.

Generally speaking, the higher an internal rate of return, the more desirable an
investment is to undertake. IRR is uniform for investments of varying types and, as
such, can be used to rank multiple prospective investments or projects on a
relatively even basis. In general, when comparing investment options with other
similar characteristics, the investment with the highest IRR probably would be
considered the best.

 The internal rate of return (IRR) is the annual rate of growth that an
investment is expected to generate.
 IRR is calculated using the same concept as net present value (NPV), except
it sets the NPV equal to zero.
 IRR is ideal for analyzing capital budgeting projects to understand and
compare potential rates of annual return over time.

Calculation for IRR

calculation used to determine this figure are as follows:

1. Using the formula, one would set NPV equal to zero and solve for the
discount rate, which is the IRR.
2. The initial investment is always negative because it represents an outflow.
 3. Each subsequent cash flow could be positive or negative, depending on the
estimates of what the project delivers or requires as a capital injection in the
future.
4. However, because of the nature of the formula, IRR cannot be easily
calculated analytically and instead must be calculated iteratively through
trial and error or by using software programmed to calculate IRR (e.g., using
Excel)

What Is IRR Used For?

In capital planning, one popular scenario for IRR is comparing the profitability of
establishing new operations with that of expanding existing operations. For
example, an energy company may use IRR in deciding whether to open a new
power plant or to renovate and expand an existing power plant. While both projects
could add value to the company, it is likely that one will be the more logical
decision as prescribed by IRR.  Note that because IRR does not account for
changing discount rates, it’s often not adequate for longer-term projects with
discount rates that are expected to vary.

IRR is also useful for corporations in evaluating stock buyback programs. Clearly,

if a company allocates substantial funding to repurchasing its shares, then the
analysis must show that the company’s own stock is a better investment—that is,
has a higher IRR—than any other use of the funds, such as creating new outlets or
acquiring other companies.

Individuals can also use IRR when making financial decisions—for instance, when
evaluating different insurance policies using their premiums and death benefits.
The general consensus is that policies that have the same premiums and a high IRR
are much more desirable. Note that life insurance has a very high IRR in the early
years of policy—often more than 1,000%. It then decreases over time. This IRR is
very high during the early days of the policy because if you made only one
monthly premium payment and then suddenly died, your beneficiaries would still
get a lump sum benefit.

Another common use of IRR is in analyzing investment returns. In most cases, the
advertised return will assume that any interest payments or cash dividends are
reinvested back into the investment. What if you don’t want to
reinvest dividends but need them as income when paid? And if dividends are not
assumed to be reinvested, are they paid out, or are they left in cash? What is the
assumed return on the cash? IRR and other assumptions are particularly important
on instruments like annuities, where the cash flows can become complex.
Finally, IRR is a calculation used for an investment’s money-weighted rate of
return (MWRR). The MWRR helps determine the rate of return needed to start
with the initial investment amount factoring in all of the changes to cash flows
during the investment period, including sales proceeds.
Q2. Cash budget is a device controls receipts and payments in period- analyze?

ANS

Cash Budget :
A cash budget is an estimation of the cash flows of a business over a specific
period of time. This could be for a weekly, monthly, quarterly, or annual budget.
This budget is used to assess whether the entity has sufficient cash to continue
operating over the given time frame. The cash budget provides a company insight
into its cash needs (and any surplus) and helps to determine an efficient allocation
of cash.

 A cash budget is a company's estimation of cash inflows and outflows over a

specific period of time, which can be weekly, monthly, quarterly, or
annually.
 A company will use a cash budget to determine whether it has sufficient
cash to continue operating over the given time frame.
 A cash budget will also provide a company with insight into its cash needs
and any surpluses, which help it determine an efficient use of cash.
 Cash budgets can be viewed as short-term cash budgets, usually, a time
frame of weeks to months, or long-term cash budgets, which are viewed as
years.
 A company must manage its sales and expenses to reach an optimal level of
cash flows.

Importance of Cash Budget :

Cash budget is an important tool in the hands of financial management for the
planning and control of the working capital to ensure the solvency of the firm.  The
importance of cash budget may be summarised as follow:

1. Helpful in Planning: Cash budget helps planning for the most efficient use of
cash. It points out cash surplus or deficiency at selected point of time and enables
the management to arrange for the deficiency before time or to plan for investing
the surplus money as profitable as possible without any threat to the liquidity. 
2. Forecasting the Future needs: Cash budget forecasts the future needs of funds,
its time and the amount well in advance. It, thus, helps planning for raising the
funds through the most profitable sources at reasonable terms and costs. 

3. Maintenance of Ample cash Balance: Cash is the basis of liquidity of the

enterprise. Cash budget helps in maintaining the liquidity. It suggests adequate
cash balance for expected requirements and a fair margin for the contingencies. 

4. Controlling Cash Expenditure: Cash budget acts as a controlling device. The

expenses of various departments in the firm can best be controlled so as not to
exceed the budgeted limit. 

5. Evaluation of Performance: Cash budget acts as a standard for evaluating the

financial performance. 

6. Testing the Influence of proposed Expansion Programme: Cash budget

forecasts the inflows from a proposed expansion or investment programme and
testify its impact on cash position.

7. Sound Dividend Policy: Cash budget plans for cash dividend to shareholders,

consistent with the liquid position of the firm. It helps in following a sound
consistent dividend policy. 

8.Basis of Long-term Planning and Co-ordination: Cash budget helps in co-

coordinating the various finance functions, such as sales, credit, investment,
working capital etc. it is an important basis of long term financial planning and
helpful in the study of long term financing with respect to probable amount,
timing, forms of security and methods of repayment.
 CLUSTER 5

Q3. IRR EQUATES PV OF AS INFLOW AND OUTFLOW IN AN

INVESTMENT OPTION – EXPLAIN?

ANS

Internal Rate of Return (IRR)

The internal rate of return (IRR) is a metric used in financial analysis to estimate
the profitability of potential investments. IRR is a discount rate that makes the net
present value (NPV) of all cash flows equal to zero in a discounted cash flow
analysis.

IRR calculations rely on the same formula as NPV does. Keep in mind that IRR is
not the actual dollar value of the project. It is the annual return that makes the NPV
equal to zero.

Generally speaking, the higher an internal rate of return, the more desirable an
investment is to undertake. IRR is uniform for investments of varying types and, as
such, can be used to rank multiple prospective investments or projects on a
relatively even basis. In general, when comparing investment options with other
similar characteristics, the investment with the highest IRR probably would be
considered the best.

 The internal rate of return (IRR) is the annual rate of growth that an
investment is expected to generate.
 IRR is calculated using the same concept as net present value (NPV), except
it sets the NPV equal to zero.
 IRR is ideal for analyzing capital budgeting projects to understand and
compare potential rates of annual return over time.

Profitability Index (PI) :

The profitability index (PI), alternatively referred to as value investment ratio
(VIR) or profit investment ratio (PIR), describes an index that represents the
relationship between the costs and benefits of a proposed project. It is calculated as
the ratio between the present value of future expected cash flows and the initial
amount invested in the project. A higher PI means that a project will be considered
more attractive.

KEY TAKEAWAYS
 The profitability index (PI) is a measure of a project's or investment's
attractiveness.
 The PI is calculated by dividing the present value of future expected cash
flows by the initial investment amount in the project.
 A PI greater than 1.0 is deemed as a good investment, with higher values
corresponding to more attractive projects.
 Under capital constraints and mutually exclusive projects, only those with
the highest PIs should be undertaken.
Q4. WHAT IS CAPITAL EXPENDITURE AND HOW IT INFLUENCE THE
FIRMS INVESTMENT POLICIES?

ANS

What Are Capital Expenditures (CapEx)?

Capital expenditures (CapEx) are funds used by a company to acquire, upgrade,
and maintain physical assets such as property, plants, buildings, technology, or
equipment. CapEx is often used to undertake new projects or investments by a
company.

Making capital expenditures on fixed assets can include repairing a roof,

purchasing a piece of equipment, or building a new factory. This type of financial
outlay is made by companies to increase the scope of their operations or add some
economic benefit to the operation.

HOW CAPITAL EXPENDITURE INFLUENCES THE FIRMS INVESTMENT

POLICIES:

Small businesses commonly make capital expenditures at one time or another.

This cost is an amount you pay to buy or upgrade a long-term asset, such as a
computer or a machine. The actual cost of a capital expenditure does not
immediately impact the income statement, but gradually reduces profit on the
income statement over the asset’s life through depreciation. However, a capital
expenditure may immediately affect the income statement in other ways,
depending on the type of asset.

About the Income Statement

An income statement shows a company’s revenue, expenses and profit for a

specific accounting period. The revenue and expenses pertain only to that period,
regardless of when money is received or paid. Because a capital expenditure
benefits a business over multiple periods, a business does not report an entire
capital expenditure on the income statement when the money is spent. It instead
reports the capital expenditure as an asset on the balance sheet.

Depreciation
A business charges a portion of the capital expenditure to a “depreciation”
expense on the income statement each period of the asset’s life. Depreciation
accounts for the use of the asset for the particular period, which reduces profit for
the period. The appropriate depreciation expense to charge each period depends
on the asset’s expected life, the asset’s estimated value at the end of its life and
how much the business plans to use the asset each period of its life.

Example

Assume your small business buys equipment for $100,000 that you plan to
depreciate by $10,000 each year of its life. You initially record $100,000 of
equipment in the assets section of the balance sheet, which does not immediately
impact the income statement. You then report a $10,000 depreciation expense on
the income statement each year of the equipment’s life. This reduces your profit
by $10,000 each year.

Upgrade vs. Maintenance

Only the purchase of new assets and upgrades to existing assets qualify as capital
expenditures. An upgrade extends an asset’s life or improves it in some way. An
example of an upgrade is the expansion of a warehouse. If a business repairs or
maintains an existing asset to simply keep it in normal working condition, it
reports the entire cost as an expense, rather than a capital expenditure, on the
income statement, which immediately reduces the company's profit.

Indirect Impact

A capital expenditure can affect the income statement in other ways. It can
increase your revenue if you buy an asset that boosts your manufacturing capacity
or sales volume. A new asset can require you to spend more on supplies,
electricity or insurance, which can increase expenses on the income statement.
For example, assume your small business buys new equipment that doubles your
production, but requires additional workers. The higher production would likely
add to your revenue, but the additional staff would increase your expenses.
 CLUSTER 6

Q5. A PROJECT PROPORSAL ESTIMATED PI IS GREATER THAN UNITY

APPROVEIT- COMMENT?

ANS

Profitability Index (PI) :

The profitability index (PI), alternatively referred to as value investment ratio
(VIR) or profit investment ratio (PIR), describes an index that represents the
relationship between the costs and benefits of a proposed project. It is calculated as
the ratio between the present value of future expected cash flows and the initial
amount invested in the project. A higher PI means that a project will be considered
more attractive.

 The profitability index (PI) is a measure of a project's or investment's

attractiveness.
 The PI is calculated by dividing the present value of future expected cash
flows by the initial investment amount in the project.
 A PI greater than 1.0 is deemed as a good investment, with higher values
corresponding to more attractive projects.
 Under capital constraints and mutually exclusive projects, only those with
the highest PIs should be undertaken.

Advantages Of Profitability Index (PI)

1. PI considers the time value of money.

2. PI considers analysis all cash flows of entire life.

3. PI makes the right in the case of different amount of cash outlay of different
project.

4. PI ascertains the exact rate of return of the project.

Disadvantages Of Profitability Index(PI)

1. It is difficult to understand interest rate or discount rate.

2. It is difficult to calculate profitability index if two projects having different
useful life.

Understanding the Profitability Index Rule :

The profitability index is calculated by dividing the present value of future cash
flows that will be generated by the project by the initial cost of the project. A
profitability index of 1 indicates that the project will break even. If it is less than 1,
the costs outweigh the benefits. If it is above 1, the venture should be profitable.

For example, if a project costs $1,000 and will return $1,200, it's a "go."

So even here the project is accepted as it is greater than unity so hence it means
that is the right decision taken because it is obviously going to generate profit.
Q6. PROFIT EARNED BY EVERY FIRM HAS TO BE DISTRUBUTED BY
EVERY PROFIT EARNING FIRM – COMMENT ?

ANS

What Is Profit?
Profit describes the financial benefit realized when revenue generated from a
business activity exceeds the expenses, costs, and taxes involved in sustaining the
activity in question. Any profits earned funnel back to business owners, who
choose to either pocket the cash or reinvest it back into the business. Profit is
calculated as total revenue less total expenses.

Not every firm has to distribute its profits. It totally depends upon the firm that
whether it has taken any common shares, preferences and debentures. If the
company has issued all these then it is important is distribute to profits.

DISTRIBUTABLE PROFITS :

The profits of a company that are legally available for distribution as dividends.
They consist of a company's accumulated realized profits after deducting all
realized losses, except for any part of these net realized profits that have been
previously distributed or capitalized.

Distributable profits are the profits of a LIMITED company that are available for
distribution to the shareholders as dividends. These are revenue reserves including
the profit and loss account and the general reserves.

 Types of Distributions

When a public company earns a profit, it decides whether to distribute excess

earnings to shareholders in the form of dividends. In most cases, companies issue
cash dividends, but they can also issue stock dividends. A cash dividend is a cash
payment, and a stock dividend represents additional shares that companies give to
their shareholders. Companies typically pay dividends every three months.
Companies are not obligated to pay dividends to shareholders, and they
sometimes cease dividend payments during unprofitable periods.

Cash Distributions Effect on Equity

When a company declares distributions to shareholders, the declaration directly

affects the retained-earnings account under the shareholder-equity section of the
balance sheet. The journal entries made with the declaration of dividends include
a debit to the retained-earnings account and a credit to the dividend-payable
account. A decrease in the shareholders’-equity account and an increase in
liabilities on the balance sheet are the result of a declaration of dividends. When
the company actually pays the dividends to shareholders, the dividends-payable
account is debited and cash is credited. The effects on the cash account are shown
on the cash-flow statement under the financing-activities section.

Reasons Companies Retain Earnings

In contrast to dividends, retained earnings represent the profits the company

chose not to distribute to its shareholders. The retained-earnings account
normally contains a credit balance. A company can calculate its retained earnings
by subtracting dividends paid to shareholders from net income. The balance in the
retained-earnings account is directly related to the net income or net losses within
a firm. A company experiencing a net income for several years usually operates
with a large retained-earnings account, and the opposite is true when a company
incurs net losses for several consecutive years.

Retained Earnings Affect on Equity

The retained-earnings account is one of the line items under the shareholders’-
equity section of the balance sheet. The other line item that falls under the section
is the paid-in capital category. An increase in retained earnings results in an
overall increase in shareholders’ equity. Dividend-paying companies must
maintain a balance between their retained-earnings account and dividends paid to
shareholders. A company may feel pressure from investors to distribute dividends
even when it needs to retain the earnings to improve its financial position.