Financial Analysis



Financial Analysis

1. Advantages and Disadvantages

Payback Period

Advantages:

Payback period is easy to calculate and easily understandable.

It involves liquidity factor when making investment decision.

Lower PB indicates lower risk of recovering cost while higher PB involves greater risk.

Disadvantages:

It does not consider time value of money.

It does not consider Cash Flow after payback period which directly impact on project profitability.

Priority is given to Liquidity as compared to Profitability.

Profitability Index

Advantages:

It considers time value of money.

It involves entire life cash flow analysis.

It shows whether investment is increasing or reducing value of the company.

It also takes into the account risk factor that is involved in cash flows.

Disadvantages:

It is not easy to understand discount rate.

Projects having different life, it would be difficult to compute PI.

Internal Rate of return.

Advantages:

IRR consider Time Value of Money factor.

For IRR, each cash flow is equally important.

IRR maximizes profitability for shareholders.

Cost of capital is not required for IRR.

Disadvantages:

Due to complex calculation, it is very difficult to understand value of IRR.

Assumptions made for IRR is not real.

IRR is not beneficial for mutually exclusive investment.

Net present Value

Advantages:

Time value is an important factor for NPV.

NPV consider both cash flows before and after project life.

NPV give importance to Project Risk and project Profitability.

It assists in explaining that with this project company would be adding value to firm (Brigham, Ehrhardt, 2011).

2. What are the most critical problems that arise in calculating a rate of return for a Prospective investment?

The critical problems that take place while calculating rate of return for Prospective investment is answering questions that are directly related to investment such as initial upfront costs, maintenance costs etc. Beside this, how much company should gain from investment is also difficult as return is always uncertain. Hence, determining Time-Line for cost and how much return would be generated is the most difficult task and on this basis on this entire rate of return is determined (Geoffrey, 2004).

3.

Security B:

Beta: 1.2

Market Rate: 22%

Treasury bill rate: 10%

Rb = Rf + (Rm - Rf) *ß

= 10% + (22% -10%)*1.2

Rb = 24.400%



Beta: 0.656

Market Rate: 13.2%

Risk free rate: 5.7%

Required rate of return: ?

Re = Rf + (Rm - Rf) *ß

Re = 5.7% + (13.2% - 5.7%) * 0.656

Re = 10.62%

6: Net present Value

Net present Value

Formula for Net Present Value =

Present value of net cash inflow - initial investment

Present value of net cash inflow = Cash flows * [1/(1+r)^n]

Project A

Years

Cash flows

Discount Rate - 14%

Discounted

Cash flow

0

-$4,000

1

-$4,000

1

$2,003

0.877192982

$1,757

2

$2,003

0.769467528

$1,541

3

$2,003

0.674971516

$1,352

4

$2,003

0.592080277

$1,186

 

Present value ...