Explain the major drawback of using payback period method (including discounted payback period method) and give an example which can provide false decision when mutually exclusive projects are considered.

You recently went to work for Jurong Parts Limited, a company listed on Catalist, which supplies auto repair parts used in the after-market automobiles like Nissan, Honda and Mitsubishi.
Chief Financial Officer of Jurong Port is concerned with which methods should be used to evaluate projects: payback period, net present value or internal rate of return.

(a) Explain the major drawback of using payback period method (including discounted payback period method) and give an example which can provide false decision when mutually exclusive projects are considered.
(6 marks)
(b) Appraise the main reason why net present value is the most appropriate method to be used in evaluating a project.
(4 marks)
(c) Jurong Port is considering two mutually exclusive projects with the following details:
Project A Project B
Life 3 years 3 years
Investment $5 million $5 million
NPV $836,000 $750,000
IRR 11% 12%
Opportunity cost 8% 8%
Since NPV method and IRR method show different decisions, explain how the difference can be reconciled.

Question 2
(a) Capital Asset Pricing Model (CAPM) is often used to calculate the cost of equity. In deciding the risk-free rate of return, you have the following information on Treasuries:
Maturity Yield
1 year 2%
10 years 4%
15 years 5%
The market risk premium is always assumed to be positive. However, in practice, it is often seen that in some years the market return is negative showing premium to be negative and some years the market return is unusually high as market returns are based on the expectation of how the economy will move.
Given this information, explain why CAPM using 10-year Treasury rate as risk-free rate and using a positive risk premium is appropriate in calculating the cost of equity.
(6 marks)
(b) Jurong Port plans to finance a new project through issue of new bonds for $10 million. Since debt is used to finance the project, the accounts manager argues that the interest paid for the bond should become part of the expenses in calculating the project’s free cash flows and these cash flows should be discounted at the after-tax cost of debt.
Prepare a statement refuting the observations of the account manager.
(8 marks)
(c) Net Present Value Method is used as the main criteria to evaluate the projects. Analyse the issues that the management should consider in using net present value and explain how these issues can be resolved.
(10 marks)

 
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