UGC NET COMMERCE July 2018 Q44
- Option : C
- Explanation : Assumptions Underlying Discounted-Cash- Flow Analysis: As is true of any decision model, discounted-cash-flow methods are based on assumptions. Four assumptions underlie the NPV and IRR methods of investment analysis.
∎ In the present-value calculations used in the NPV and IRR methods, all cash flows are treated as though they occur at yearend. If the city of Mountainview were to acquire the new street cleaner, the $14,000 in annual operating-cost savings actually would occur uniformly throughout each year. The additional computational complexity that would be required to reflect the exact timing of all cash flows would complicate an investment analysis considerably. The error introduced by the year-end cash-flow assumption generally is not large enough to cause any concern.
∎ Discounted-cash-flow analyses treat the cash flows associated with an investment project as though they were known with certainty. Although methods of capital budgeting under uncertainty have been developed, they are not used widely in practice. Most decision makers do not feel that the additional benefits in improved decisions are worth the additional complexity involved. As mentioned above, however, risk adjustments can be made in an NPV analysis to partially account for uncertainty about the cash flows.
∎ Both the NPV and IRR methods assume that each cash inflow is immediately reinvested in another project that earns a return for the organization. In the NPV method, each cash inflow is assumed to be reinvested at the same rate used to compute the project’s NPV, the organization’s hurdle rate. In the IRR method, each cash inflow is assumed to be reinvested at the same rate as the project’s internal rate of return.
What does this reinvestment assumption mean in practice? In the case of Mountainview’s proposed new street cleaner, the city must instantly reinvest the money saved each year either in some interest-bearing investment or in some other capital project.
∎ A discounted-cash-flow analysis assumes a perfect capital market. This implies that money can be borrowed or lent at an interest rate equal to the hurdle rate used in the analysis.
In practice, these four assumptions rarely are satisfied. Neverthless, discounted-cash-flow models provide an effective and widely used method of investment analysis. The improved decision making that would result from using more complicated models seldom is worth the additional cost of information and analysis.
