Questions of chapter 12
Sunk costs are those which have been incurred in the past and cannot be recovered. Therefore they are irrelevant to a new project because they don’t affect investor’s decision regarding viability of a project. Hence, it is illogical to include them in determination of cash flow associated with a project that is why they are excluded in the calculation of cash flow (Titman, Keown, & Martin,2011).
In computation cash flows associated with an investment Loan principal amount and interest rate are cash out flows relating to financing activities (financial costs). However this may not be included in the computation of cash flows because they do not affect cash flow of the operating activities. These costs do not affect the core activities of the business. The main aim will be to consider whether adequate cash inflows can be raised to not only cover the interest payment but also recoup the principle amount (Titman, Keown, & Martin,2011).
When preparing cash flow statement for sale of internet services on airlines it is important to group cash flows from various activities together according to their categories. All cash flows from operating activities should be distinct from those from financing activities as well as cash flows from investing activit ies. Examples of cash from operating activities are sale of software, sale of rights to access certain sites etc. cash flows associated with capital expenditures are interest from loans and bank overdrafts among other costs. Cash out lay consists of cost of purchasing gadgets to enhance internet connections in the airlines.
Investment ideas can be obtained from various sources. The most suitable source is careful evaluation of industrial trends. This includes political, legislative or economic changes that impact competitive environment which a company mostly operate in. however, investment idea can also be obtained through brain storming so as to come up with a very unique idea which may solve a particular problem in the society. Other sources include: learning from companies operating in other countries, reading business news from magazines and economic journals etc.
The following are the main limitations a company faces when payback period is used in determining whether to invest in a project. First, it does not consider time value of money. Secondly, cash flows beyond payback period are ignored which if considered may make the investor to change his decision. Third, the formula does not provide any criteria to determine whether a new project would increase firm’s value. Lastly, it ignores all the risks associated with future cash flows expected from the new project. However, this method is popular among investors because of its advantages. The main merit is that, it clearly determines how long it takes for the new project to generate adequate cash flows to recoup initial investment. Other merits are first, it is very simple to compute because cash flows are simply added until they level initial cost of investment. Finally, the method provides a crude way of measuring risk associated with the investment. Where by, the longer it takes to recoup initial investment the higher the risk associated with the investment.
Discounted payback period considers time value of money unlike Payback period. It is therefore impossible for both to provide identical results unless when discount rate is zero.
Titman, S., Keown, A. J., & Martin, J. D. (2011). Financial management: principles and applications (11th ed.). Boston: Prentice Hall.