CAIIB Paper 3 Module B Quiz 3

NPV equals the present value of expected cash inflows less the present value of cash outflows, discounted at the required return. A positive NPV indicates value creation under the forecast assumptions.

IRR is the rate that makes the present value of project cash inflows equal the present value of cash outflows, so NPV is zero. It should be compared with an appropriate required return.

Conventional payback focuses on how quickly the initial outlay is recovered and ignores later cash flows. It also ignores time value of money unless discounted payback is used.

Discounted payback discounts project cash flows to reflect time value of money before finding the recovery period. However, it still ignores cash flows after the payback point.

Profitability index = present value of future cash inflows ÷ initial investment = 12/10 = 1.20. A PI above 1 corresponds to a positive NPV for a conventional project.

An annuity present value factor discounts a series of equal periodic cash flows. Multiplying the annual inflow by the factor gives the present value of the annuity, assuming the timing and discount rate are consistent.

Relevant project cash flows are incremental cash flows that arise because the project is undertaken. Sunk costs are excluded, while genuine opportunity costs and incremental overheads should be considered.

The study cost has already been incurred and cannot be changed by the current decision, so it is a sunk cost. Capital budgeting should focus on future incremental cash flows.

Using an asset prevents the firm from receiving the best alternative benefit. The foregone sale proceeds are an opportunity cost and should generally be included in project analysis.

Additional inventory and receivables net of spontaneous liabilities tie up cash, so the increase in net working capital is a project cash outflow. If released at the end, its recovery is a terminal cash inflow.

Depreciation is a non-cash expense, but where deductible it reduces taxable profit and creates a tax shield. The cash-flow effect is the tax saving, not the depreciation charge itself.

Replacement analysis compares the future cash flows of the replacement option with those of continuing to use the existing asset. Relevant items include purchase cost, operating savings, disposal proceeds, tax effects and working capital.

The profitability index relates present value of inflows to investment outlay and can help rank divisible projects when capital is constrained. With indivisible projects or other constraints, a combination optimisation may be needed.

NPV measures the expected absolute addition to value and is generally preferred for mutually exclusive projects. IRR can misrank projects when scale, timing or cash-flow patterns differ.

A positive NPV indicates value creation in isolation, but capital rationing can prevent the firm from accepting every positive-NPV project. The firm should select the best feasible portfolio under the constraint.

Social cost-benefit analysis evaluates effects on society, including externalities and non-market impacts where they can be estimated. Shadow prices and social discounting may be needed where market prices do not reflect social value.

Pollution imposes costs on third parties that may not be reflected in the firm’s private cash flows. A social appraisal attempts to account for such negative externalities.

Sales forecasts inform expected demand; production plans translate demand into output and capacity requirements. Capital budgets should be consistent with these operating plans to avoid under- or over-investment.

Cash forecasts map expected receipts and payments over time. They help plan borrowing, investment of surplus cash and liquidity buffers, while remaining subject to forecasting uncertainty.

If project working capital is released at closure, the expected recovery is a terminal inflow. The estimate should reflect realistic recoverability and any remaining inventory or receivables losses.