Question

This week we are studying Project Cash Flows and Capital Budgeting and I am stuck on the below and would like some help.

The Federal Reserve lowers interest rates in the economy to increase economic activity. Using the capital budget decision tools, discuss how decreasing interest rates can cause firms to make more investments.

How is the pro forma statement we used in this chapter for computing OCF different from an accountant’s income statement?

Why does a decrease in NWC result in a cash inflow to the firm?

Which should we expect to be larger: a project’s payback statistic, or its discounted payback statistic?

Suppose a company faced different borrowing and lending rates. How would this range change the way that you would compute the MIRR statistic

Answer 1

(1): Decreasing interest rates will help a company to increase its NPV i.e. net present value. We know that NPV = sum of all present values and present value = amount of cash flow/(1+r)^n where r is the interest rate and n is the time period.

Suppose that amount of cash flow is -$100 in 1^st year and $500 in 2^nd year and interest rate is 5%. Thus NPV will be:

Year	Cash flow	1+r	PVIF	PV
1	-100	1.05	0.9524	-95.24
2	500		0.9070	453.51
			NPV	358.28

If interest rate declines to 4% now then NPV will increase as can be seen below:

Year	Cash flow	1+r	PVIF	PV
1	-100	1.04	0.9615	-96.15
2	500		0.9246	462.28
			NPV	366.12

(2): The pro forma statement used in this chapter is different from an accountant’s income statement as an accountant’s income statement includes various things about a company with regards to its income and expenses. On the other hand a pro forma statement makes use of income statement and balance sheet to evaluate the financial impact of a project on the company.

(3): Decrease in NWC means that either the current assets of the company have decreased or its current liabilities have increased. Decrease in current assets like accounts receivable means that customers are paying up more regularly and hence cash inflow is occurring faster and also higher. Increase in current liabilities like accounts payable means that the company is able to increasingly buy goods and inventories on credit and not on cash. These leads to increase in cash inflows.

(4): Discounted payback statistic will be larger because time value of money is considered and hence money that will be received later will be discounted more and hence will have a lesser present value. This will make discounted payback statistic larger than the standard payback statistic.

(5): This range will change the way you would compute the MIRR statistic as you would want to make use of the lending rate to move the positive cash flows to the end of the project and use the borrowing rate to move the negative cash flows closer to time 0.