Question 1

Monica and Rachel are having a discussion about IRR and NPV as a decision model for Monica's new restaurant. Monica wants to use IRR because it gives a very simple and intuitive answer. Rachel states that there can be errors made with IRR that are not made with NPV. Elaborate a type of error can be made with IRR but not with NPV.  

Question 2

Explain how the zero-coupon rate bond provides return to the investor and elaborate on the advantages to the corporation. 

Question 3

Cash flow statement is one of the important statements to financial managers. Explain the three main categories of this statement. 

 

Answer 1

Meaning of IRR: internal rate of return refers to the rate at which th present value of future cash flows is equal to the initial investment made in a particular project.

Meaning of NPV: Net present value is the discounted future cash flows less the initial investment. The decision of taking up a project is taken when the NPV of the particular project is positive.

Type of error can be made with IRR but not with NPV :

While using IRR it is assumed that the proceeds of the project are reinvented at IRR of project, which is wrong.

Whereas NPV assumes that the proceeds are reinvented at the rate corresponding to the cost of capital.

Thus, NPV is considered better than IRR.

Answer 2

• Zero coupon bond provide the investor with one repayment being received. For example a zero coupon bond is issued by an entity at $6 and it will be redeemed at $ 10. Then the investor will earn in form of diffrential ( 10-6) as return. In this, bond is usually issued at discount and redeemed at par.
• Benefits to corporation: The issuing entity benefits in form of liquidity as the entity once raise funds through zero coupon bond is required to reqeem it at maturity with no payment of interest or repayment of principal in between. Thus, provides funds for a long time.

Answer 3

The three main categories of cash flow statement are

1. Cash flows from operating activities
2. Cash flows from investing activities
3. Cash flows from financing activities

Explanation:

All the cash flows relating to normal operations of entity are to be considered here, for example receipts from customers, payment to supplier etc. Moreover there are two methods to reach at cash flows from operating activities, those methods are (1) Direct method (2) indirect method.

All the cash flows from investment like purchase of plant and machinery, sale of land etc are covered here.

All the cash flows relating to financing are covered under third category. For example taking bank loan, paying of interest etc.