Question

Question 2 A. In discounting the cash flows of a project, the opportunity cost of capital is of significant importance. How this interest rate is selected and what may be the implications of selecting either a higher or a lower one than the appropriate? Describe the process for a company operating under uncertainty, in comparing and choosing between two mutually exclusive investment projects B. C. Describe the Degree of Operational Leverage, as it is important in company profitability. However, could you also derive a further important implication of this ratio, in long-term company investment decision making?

Answer 1

A. Opportunity cost of capital is the rate at which the expected future cash flows of a project are discounted to ascertain the present value of the project. If the present value is more than the investment required today (i.e. Net Present Value > 0), then the project can be selected for further action.

Methods of selecting the opportunity cost or discount rate:

I. Weighted Average Cost of Capital: This is the simplest method and involves calculated the weighted cost of all the funds available to the investor for this project. It is important to note here that the funds arranged by the investor may come from the strength of the balance sheet of the investor and not considering the characteristics of the project where funds are to be applied. The second method overcomes this shortfall.

II. Risk based costing: All the risks of the project are identified and appropriate premium is allocated for each risk and then these premiums are added on to the risk free rate to obtain the appropriate discount rate.

The higher the discount rate the lower is the present value, and therefore if we select a discount rate higher than appropriate we may reject a good project and if we select discount rate lower than appropriate, we may accept a bad project.

B. While comparing two mutually exclusive investment projects, the most ideal comparison can be made using the NPV of each of the projects. The project having higher NPV can be preferred over project with lower NPV.

For a company operating under uncertainty, it is important to examine the risk based costing of each of the projects individually to calculate the respective NPV instead of using the same discount rate for each project. Also, the shareholding requirements and exit strategy should be well planned for contingency events.

C. Degree of Operating Leverage (DOL) is % change in earnings before interest and taxes to % change in sales.

The higher the DOL, the higher is the sensitivity of a company's profitability to its sales. Companies with higher fixed costs have higher DOL as fixed costs are distributed over sales. In long term investment decision making it is better to have lower fixed costs and higher variable costs as during times of uncertainty or lower sales the profitability is not impacted on a increasing scale.