Statement - II : Both the NPV and the IRR methods of investment appraisal are based on discounted cash flow approach.
Analyzing Investment Appraisal Statements
This section evaluates two statements related to investment appraisal techniques used in finance.
Critique of Statement I: Accept-Reject Approach Use
Statement I claims the accept-reject approach is generally adopted when a firm has substantial funds to invest in multiple projects simultaneously. This statement is incorrect because:
- The accept-reject method is a basic decision rule used to evaluate individual projects based on whether they meet a minimum acceptable return or criterion (like positive NPV).
- When funds are ample and not a constraint, a firm might accept all projects that individually meet the acceptance criteria.
- However, if funds are limited (capital rationing), simply using accept-reject for each project isn't sufficient. Techniques like the Profitability Index (PI) are often used to rank projects and select the optimal combination, prioritizing those giving the best return per unit of scarce capital. The statement mischaracterizes the typical application and context of the accept-reject approach.
Validation of Statement II: NPV and IRR Basis
Statement II asserts that both the Net Present Value (NPV) and Internal Rate of Return (IRR) methods rely on the discounted cash flow (DCF) approach. This statement is correct:
- NPV Method: Calculates the difference between the present value of future cash inflows and the initial investment cost. It explicitly uses a discount rate (cost of capital) to bring future cash flows back to their present value, accounting for the time value of money.
- IRR Method: Identifies the specific discount rate at which the NPV of all cash flows (both positive and negative) from an investment equals zero. This calculation inherently involves the process of discounting future cash flows.
- Both NPV and IRR are widely recognized as primary DCF techniques because they fundamentally rely on the principle of discounting future cash flows to evaluate investment profitability.
Conclusion: Statement I is incorrect, while Statement II is correct.
Important Questions from Capital budgeting decisions
Indicate the correct code for discounted cash flow techniques for capital investment proposals from the following:
(i) Net Present Value Method
(ii) Internal Rate of Return method
(iii) Excess Benefit-Cost Ratio method
(iv) Net Terminal Value method
Choose the correct answer from the code given below :
Break even analysis is also known as:
- Under which one of the following situation a firm can not raise capital for a project under any circumstance ?
- Which of the following statement about Finance lease is NOT true ?
(i) Finance lease transfer substantially all the risks and rewards incidental to ownership of an asset.
(ii) The lease period in a finance lease covers a substantial portion of the asset's economic life.
(iii) Payment towards lease rental in finance lease cover all cast incurred by lessor in obtaining the assets.
(iv) Finance lease is considered short-term in nature. - Assertion (A): Compounding interest allows an investment to grow faster over time compared to simple interest.
Reason (R): Simple interest earns interest on Previously earned interest.
