Master of Business Administration

Financial Management of the Future

Assignment II

Prepared by: Maged Mohammed Zohier

Under supervision: Dr. Hesham Khalil

Assignment:
Financial Management IBSS- Quiz 2

Questions
1. What is the internal rate of return IRR? (5)
Definitions of internal rate of return IRR:
Internal rate of return: is the discount rate at which the PV of the initial cash outflow = the PV of the
expected cash inflow.

The internal rate of return on an investment or project is the "annualized effective compounded return rate"
or rate of return that sets the net present value of all cash flows (both positive and negative) from the
investment equal to zero. Equivalently, it is the discount rate at which the net present value of future cash
flows is equal to the initial investment, and it is also the discount rate at which the total present value of
costs (negative cash flows) equals the total present value of the benefits (positive cash flows).

Speaking intuitively, IRR is designed to account for the time preference of money and investments. A given
return on investment received at a given time is worth more than the same return received at a later time, so
the latter would yield a lower IRR than the former, if all other factors are equal. A fixed income investment in
which money is deposited once, interest on this deposit is paid to the investor at a specified interest rate
every time period, and the original deposit neither increases nor decreases, would have an IRR equal to the
specified interest rate. An investment which has the same total returns as the preceding investment, but
delays returns for one or more time periods, would have a lower IRR. This lower IRR would indicate the
interest rate of a fixed income investment that would have the same overall value as the delayed investment.
Internal Rate of Return Model:
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.

The IRR is the discount rate at which NPV = zero or is the discount rate that equates the PV of the expected
net cash flows (CFs) with the initial cash outflow (ICO).

Uses of IRR:
Profitability of an Investment:
Corporations use IRR in capital budgeting to compare the profitability of capital projects in terms of the
rate of return.
For example, a corporation will compare an investment in a new plant versus an extension of an existing
plant based on the IRR of each project. To maximize returns, the higher a project's IRR, the more desirable
it is to undertake the project. If all projects require the same amount of up-front investment, the project
with the highest IRR would be considered the best and undertaken first.
Maximizing Net Present Value:
The internal rate of return is an indicator of the profitability, efficiency, quality, or yield of an investment.
This is in contrast with the net present value, which is an indicator of the net value or magnitude added by
making an investment.
Applying the internal rate of return method to maximize the value of the firm, any investment would be
accepted, if its profitability, as measured by the internal rate of return, is greater than a minimum

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 acceptable rate of return. The appropriate minimum rate to maximize the value added to the firm is the
cost of capital, i.e. the internal rate of return of a new capital project needs to be higher than the
company's cost of capital. This is because an investment with an internal rate of return which exceeds the
cost of capital has a positive net present value.
However, the selection of investments may be subject to budget constraints, or they may be mutually
exclusive competing projects, such as a choice between or the capacity or ability to manage more projects
may be practically limited. In the example cited above, of a corporation comparing an investment in a new
plant versus an extension of an existing plant, there may be reasons the company would not engage in both
projects.
Fixed Income:
IRR is also used to calculate yield to maturity and yield to call.
Liabilities:
Both the internal rate of return and the net present value can be applied to liabilities as well as
investments. For a liability, a lower internal rate of return is preferable to a higher one.
Capital Management:
Corporations use internal rate of return to evaluate share issues and stock buyback programs. A share
repurchase proceeds if returning capital to shareholders has a higher internal rate of return than candidate
capital investment projects or acquisition projects at current market prices. Funding new projects by raising
new debt may also involve measuring the cost of the new debt in terms of the yield to maturity (internal
rate of return).
Private Equity:
IRR is also used for private equity, from the limited partners' perspective, as a measure of the general
partner's performance as investment manager.
This is because it is the general partner who controls the cash flows, including the limited partners' draw-
downs of committed capital.

2. What is the payback period PBP? (5)

Definitions payback period PBP:
Payback means that we have to recover the amount of money that we have to used in the investment. So
term Payback Period is the number of years required to recover the initial investment or cost.
OR
Payback Period (PBP) is one of the simplest capital budgeting techniques. It calculates the number of years
a project takes in recovering the initial investment based on the future expected cash inflows.
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.
Purpose:
Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for
most individuals, regardless of academic training or field of endeavor. When used carefully or to compare
similar investments, it can be quite useful. As a stand-alone tool to compare an investment to "doing
nothing," payback period has no explicit criteria for decision-making (except, perhaps, that the payback
period should be less than infinity).
The payback period is considered a method of analysis with serious limitations and qualifications for its use,
because it does not account for the time value of money, risk, financing, or other important considerations,

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 such as the opportunity cost. Whilst the time value of money can be rectified by applying a weighted
average cost of capital discount, it is generally agreed that this tool for investment decisions should not be
used in isolation. Alternative measures of "return" preferred by economists are net present value and
internal rate of return. An implicit assumption in the use of payback period is that returns to the
investment continue after the payback period. Payback period does not specify any required comparison to
other investments or even to not making an investment.
Payback Model:
Payback time, or payback period, is the time it will take to recoup, in the form of cash inflows from
operations, the initial dollars invested in a project.
P = I Incremental inflow
Acceptance Criteria / Evaluation / Interpretation of payback period PBP:
The acceptance criterion is simply the benchmark which is set by a firm. Some firms may not find it
comfortable to invest in very long term project and wish to enter where they can see results in say medium
to long term. Similarly, the others may take the longer term risk.
To evaluate a project on the basis of this, we can interpret a project with lower payback period to be better
as the investor is standing safely with his money back. Who would not like to get the principal back as early
as possible?
Advantages and disadvantages:
The most important advantage of this method is that it is very simple to calculate and understand. If the
manager requires a rough idea about the time frame for which the money would be blocked, he need not
sit with a pen, paper or a computer. It can be calculated on our fingertips. It can at least tell the manager
whether the project is worth spending further analysis time or not.
There are two disadvantages of this method:
One, it does not consider the cash flows after the payback period. Because of this, we cannot consider two
projects with the same payback period as equally good. This method will give the same rating to two
projects with same initial cash flow of 100 million where cash inflow of one is 50 million in first two years
and the other is 50 million for three years.
Second, it does not consider the time value of money. So, it is avoiding the basic rule of finance i.e. a dollar
today is worth more than a dollar a year later. In PBP, we calculate the years where the total investment is
recovered. In true sense, it is only the principal which is covered; the portion of interest is still to be
covered.
Other drawbacks include its inability to deal with uneven cash flows with negative cash flows in between. It
may result in dual results.

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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 plus an additional
share of the total amount of declared dividends. (False)

3. A corporation does not continue in existence even if a stockholder dies or withdraws from the
organization. (False)

4. Treasury stock is stock of a corporation that has been issued and then reacquired and then
cancelled. (False)

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 liquidation & to receive
dividends. (True)

7. In the event of the liquidation of a corporation, treasury stock ordinarily has preference as to
liabilities, while preferred stock has preference as to assets. (False)

8. Preferred stockholders generally do not have the same voting rights as do common stockholders in a
corporation. (True)

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 corporation if all shares of
stock are owned by the officers of the corporation. (False)

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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.

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 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?
A. $117,000.
B. $341,000.
C. $327,000.
D. $177,000.

Method of solution:
2(16,000 x $7) + ($1.95 x 60,000) = $341,000

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?

Method of Solution:
Bond Income/year = $10,000 *8% = $800 / year
Expected the first year = $800 (1+10%)1 = $800 (1.1)1 =$727.27
Expected the second year = $800 (1+10%)2 = $800 (1.1)2 =$661.16
Expected the third year and bonds = ($10,000+800) (1+10%)3 = ($10,800) (1.1)3=$8114.2
Total Present Value PV = $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 is to be under the life of the bonds.
Note:
If the Contract rate Market rate = bonds selling at a discount.

Best regards
Maged Mohammed Zohier

Thank you

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