Financial Management

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QUESTION 1 Net present value (NPV), also called net present worth (NPW), is an approach to evaluating investments that assesses the difference between all the revenue the investment can be expected to achieve over its whole life and all the costs involved, taking inflation into consideration inflation and discounting both future costs and revenue at an appropriate rate. It can be challenging to calculate NPV because it is not always clear what discount rates should be used. The theoretical justifications for the use of NPV decision rules in investment are as follows 1. Cash flow is what's relevant Using the formula for calculating the NPV you need to estimate the relevant cash flow. But what is cash flow? Cash flow can be described…show more content…
In terms of mathematical notation, this would be shown as -, +, +, +, +, +, denoting an initial outflow at time period 0, and inflows over the next five periods. The term is particularly used in discounted cash flow (DCF) analysis. A conventional cash flow would have only one internal rate of return (IRR), making it a relatively easy task to choose among several projects or investments with such cash flows. A mortgage is a good example of a typical conventional cash flow. For example, a financial institution lends $300,000 to a homeowner or real estate investor at a fixed interest rate of 5% for 30 years. The lender then receives approximately $1,610 per month (or $19,325 annually) from the borrower towards mortgage principal repayment and interest. If annual cash flows are denoted by mathematical signs from the lender's point of view, this would appear as an initial -, followed by + signs for the next 30 periods. While this has the advantage of ease of computation and interpretation, it is weak because it takes no account of interest rate or the precise profile of the positive cash flow. It is suitable as a quick rule of thumb for simple investment decisions but is not suitable for complex projects particularly during periods of high interest rates. It may also be used as a method of verifying answers obtained using a more sophisticated method in case a decimal point has been mislaid! In the

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