Lesson-6 on Finance

Question:  What is profitability Index (PI) Method in Capital Budgeting?

Answer:

A method used in discounted cash flow for ranking a range of projects under consideration in which standard cash flow patterns are projected. It is calculated as follows:

               
Profitability Index =  Present value of future cash flows/ Initial investment
                                     

The projects with a PI of less than 1 are not expected to earn the required rate of return and are rejected.

 Question: Which is a better measure for capital budgeting, IRR or NPV?

Answer:

All other things being equal, using internal rate of return (IRR) and net present value (NPV) measurements to evaluate projects often results in the same findings. However, there are a number of projects for which using IRR is not as effective as using NPV to discount cash flows.

IRR's major limitation is also its greatest strength: it uses one single discount rate to evaluate every investment.

The NPV method is inherently complex and requires assumptions at each stage - discount rate, likelihood of receiving the cash payment, etc.

The IRR method simplifies projects to a single number that management can use to determine whether or not a project is economically viable. The result is simple, but for any project that is long-term, that has multiple cash flows at different discount rates, or that has uncertain cash flows - in fact, for almost any project at all - simple IRR isn't good for much more than presentation value.

Question:  What is Capital Market Efficiency?

Answer:

Capital market efficiency  reflects the relative amount of wealth wasted in making transactions. An efficient capital market allows the transfer of assets with little wealth loss.

Question: What is commercial risk?

Answer:

Commercial risk The risk that a foreign debtor will be unable to pay its debts because of business events, such as bankruptcy.

Question: What is the difference between risk and uncertainty in capital budgeting?

Answer:

Ø Risk is present when future events occur with measurable probability. 

Ø Uncertainty is present when the likelihood of future events is indefinite or incalculable

 

Question: What is Sensitivity Analysis?

Answer

Ø Sensitivity analysis is done to know what will happen to the viability of the project when variable is changed from its expected value at a time.

Ø Variables are not interrelated.

 

Question: What is Scenario Analysis ?

Answer:

Ø Scenario Analysis is done to know what will happen to the viability of the project when more than one variable is changed at a time.

Ø Here variables are interrelated.

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