Assignment II - Quiz 2

MASTER OF BUSINESS
ADMINISTRATION
Financial Management
of the Future
Assignment No. II: Quiz 2
Prepared by:
Tawfik AbdelMajeed Aydieh
Supervised by:
Dr. Hesham Khalil
November, 2017
Financial Management – IBSS- Quiz 2
Questions
1. What is the internal rate of return IRR?
Internal Rate of Return (IRR): is the discount

rate at which the PV of the initial cash outflow
= the PV of the expected cash inflow.
IRR is a metric used in capital budgeting

measuring the profitability of potential
investments. Internal rate of return is a
discount rate that makes the net present value
(NPV) of all cash flows from a particular
project equal to zero. IRR calculations rely on
the same formula as NPV does.
IRR is the interest rate at which the net present value of all the cash flows (both positive and
negative) from a project or investment equal zero.
Decision Criterion – Accept if IRR > cost of capital and reject if IRR < cost of capital.
What is the IRR used for?

Companies take on various projects
to increase its revenue or cut down
costs. A great new business idea
may require investing in the
development of a new product to
achieve this goal.  The IRR determines the interest rate at which the NPV equals zero.
 If IRR > minimum desired rate of return, then NPV > 0 & accept the project.
 If IRR < minimum desired rate of return, then NPV < 0 & reject the project
In capital budgeting, senior
managers would like to know the return on these investments, and the IRR is one method
that allows them to compare and rank projects based on their yield, and the one with the
highest IRR is usually preferred.
Internal rate of return is used to evaluate the attractiveness of a project or investment. If the
IRR of a new project exceeds a company’s required rate of return, that project is desirable. If
IRR falls below the required rate of return, the project should be rejected.
IRR allows managers to rank projects by their overall rates of return rather than their net
present values, and the investment with the highest IRR is usually preferred. Ease of
comparison makes IRR attractive, but there are limits to its usefulness. For example, IRR
works only for investments that have an initial cash outflow (the purchase of the investment)
followed by one or more cash inflows.
Also, IRR does not measure the absolute size of the investment or the return. This means
that IRR can favor investments with high rates of return even if the dollar amount of the
return is very small.
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IRR is best-suited for analyzing venture capital and private equity investments, which
typically entail multiple cash investments over the life of the business, and a single cash
outflow at the end via IPO or sale.
Advantages and Disadvantages of Internal Rate of Return (IRR)

Advantages and disadvantages of internal rate of return are important to understand before
applying this technique to the projects. Most projects are well analyzed and interpreted by
this well-known technique of evaluation and selection of investment projects. This technique
has certain limitations in analyzing certain special kinds of projects like mutually exclusive
projects, an unconventional set of cash flows, different project lives etc.
Advantages Disadvantages
1. Tells whether an investment increases 1. Requires an estimate of the cost of capital in

the firm's value order to make a decision
2. Considers all cash flows of the project 2. May not give the value-maximizing decision when
used to compare mutually exclusive projects
3. Considers the time value of money
3. May not give the value-maximizing decision
4. Considers the risk of future cash flows
when used to choose projects when there is
(through the cost of capital in the
capital rationing
decision rule)
4. Cannot be used in situations in which the sign of
the cash flows of a project change more than
once during the project's life
2. What is the Payback Period PBP?
Payback period (PBP):

“Payback” means that we have to recover the
amount of money that we have to use in the
investment. So term “Payback Period” is the number
of years required to recover the initial investment or
cost.
Payback period of an investment project tells us the number of years required to recover our
initial cash investment based on the project’s expected cash flows. P = I ÷ Incremental inflow.
Decision Criterion – We will accept the project if the payback period is less than or equal to
the maximum acceptance payback period. Otherwise we can also choose the project with the
shortest payback period
Advantages Disadvantages
1. Simple to compute 1. No concrete decision criteria to indicate

2. Provides some information on the risk of whether an investment increases the firm's
the investment value
3. Provides a crude measure of liquidity 2. Ignores cash flows beyond the payback period
3. Ignores the time value of money
4. Ignores the risk of future cash flows
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True/ false
Answer the following (each one of 5)
1. Contributed capital is part of the paid-in capital. False
2. Cumulative preferred stock means the stock is entitled to its regular dividend
False
plus an additional share of the total amount of declared dividends.
3. A corporation does not continue in existence even if a stockholder dies or

False
withdraws from the organization.
4. Treasury stock is stock of a corporation that has been issued and then
False
reacquired and then cancelled.
5. A stock split will decrease the total par value of the stock. False
6. Preferred stockholders are owners of the corporation & have rights upon
True
liquidation & to receive dividends.
7. In the event of the liquidation of a corporation, treasury stock ordinarily has

False
preference as to liabilities, while preferred stock has preference as to assets.
8. Preferred stockholders generally do not have the same voting rights as do

True
common stockholders in a corporation.
9. By going public a corporation can raise equity capital from many investors. True
10. Stockholders of a corporation are personally liable for the debts of the
False
corporation if all shares of stock are owned by the officers of the corporation.
MCQs & problems
Answer the following 4 MCQs & problem (each one of 10)

1. Shares that have been sold and are in the hands of stockholders are called:
A. Outstanding.
B. Issued.
C. Treasury.
D. Underwritten.
2. When shares of stock are sold from one investor to another, they will trade at:
A. Par value.
B. Book value.
C. Market value.
D. Stated Value.
3. Topper Corporation has 60,000 shares of $1 par value common stock and 16,000 shares of
cumulative 7%, $100 par preferred stock outstanding. Topper has not paid a dividend for the prior
year. If Topper declares a $1.95 per share dividend this year, what will be the total amount they
must pay their shareholders?
Page 4 of 5
A. $117,000.
2 (16,000 x $7) + ($1.95 x 60,000) = $341,000
B. $341,000.
C. $327,000.
D. $177,000.
4. $10,000 in bonds, 8% contract rate maturing in 3 years, interest paid annually, & market rate of
10%.
Required: Calculate the carrying value (market value) of these bonds today?
Bond Income/year = $10,000 X 8% = $800 / year

Expected year 01 = $800 ÷ (1.1)1 = $727.27
Expected year 02 = $800 ÷ (1.1)2 = $661.16
Expected year 03 and bonds = ($1000+800) ÷ (1.1)3 = $8114.2
Total Present Value = $727.27 + $661.16 + $8114.2 = $9502.63
The carrying value (market value) of these bonds today = $10,000 - $9502.63 = $497.37
The $497.37 discount
Page 5 of 5

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MASTER OF BUSINESS

1. What is the internal rate of return IRR?

Internal Rate of Return (IRR): is the discount

IRR is a metric used in capital budgeting

What is the IRR used for?

Advantages and Disadvantages of Internal Rate of Return (IRR)

1. Tells whether an investment increases 1. Requires an estimate of the cost of capital in

2. What is the Payback Period PBP?

Payback period (PBP):

1. Simple to compute 1. No concrete decision criteria to indicate

1. Contributed capital is part of the paid-in capital. False

3. A corporation does not continue in existence even if a stockholder dies or

7. In the event of the liquidation of a corporation, treasury stock ordinarily has

8. Preferred stockholders generally do not have the same voting rights as do

MCQs & problems

Answer the following 4 MCQs & problem (each one of 10)

Bond Income/year = $10,000 X 8% = $800 / year

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