A Q/A Session

Sir, in chapter-10 problem-13 it is said "the sausage system will save the firm $130,000 in pretax operating costs". Is this the EBIT? In problem-14 it is said "you will save $330,000 before taxes per year in order processing costs and you will be able to reduce working capital by $125,000 (this is a one time reduction)". Is the $330,000 the EBIT? Is the $125,000 the change in NWC at the end of the project?

For problem 13, we may use the “Tax Shield Approach” to calculate OCF. In that case, the given pretax OCF is just “Sales – Costs” part of the equation. We may also use the basic approach, OCF = EBIT + Depreciation - Taxes. In this case, given pre-tax OCF is actually “OCF + Taxes” leaving “EBIT + Depreciation” on the other side of the equation.

For problem 14, ‘saving $330,000 before taxes per year’ is actually referring to the pretax OCF, not EBIT. So, we solve this problem using similar approach as discussed above for problem 13. Accepting this project means that we will reduce NWC. This reduction in NWC is a cash inflow at Year 0. This reduction in NWC implies that when the project ends, we will have to increase NWC. So, at the end of the project, we will have a cash outflow to restore the NWC to its level before the project.

Sir, sometimes the correct IRR is something like 19.78% , and its very difficult to find out the correct figure as it is too time consuming by using trial and error method . Can we just give the approximate figure , would you deduct any marks for that . like suppose the correct IRR is 19.78% and if i write "IRR is 19.7% could be little higher than that."

Rounding 19.78% to 19.8% (instead of 19.7%) will do.

Sir, how do we calculate capital gains yield?

Capital gains yield is simply percentage change in price. For a stock, the capital gains yield will be the change in price divided by the original (purchase) price expressed in percentage. For example, suppose you purchased a share of ABC Corporation for $200 and later sold the share for $220. The capital gains yield for that investment would be = [(220-200)/200]x100 = 10%. Similarly, if you sell at a lower price (less than the purchase price), your capital gains yield would be negative.

Sir, in chapter-6 for problem 24 we use the periodic rate right? but for problem 25 should we use APR or EAR? unless it is stated in the question that we are comparing between two investments, we are supposed to use APR. is my concept correct?

Please see the answer to the following question. For all types of TVM calculations, we need APR to find out periodic interest rate. So, for both problems you need APR.

Sir, when we calculate the future or present value of an annuity and we need the annual rate of return, which rate do we have to use? APR or EAR?

For Time Value of Money (TVM) calculations we need to use periodic interest rate (not necessarily annual rate, it may be a monthly rate, or a quarterly rate depending on the situation). That means for annual periods (annual compounding) we need to use APR, for monthly periods (monthly compounding) we need to divide APR by 12 (if monthly rate is not given in the problem) to get monthly rate, and so on.

However, we need EAR to compare different investment alternatives.

Sir, I am having great difficulty understanding the rates of return. When it is said "with monthly compounding" or "compounded monthly" it is the APR right? We divide it by 12 to get the actual rate per month right? When it is said say 14% per month it is the actual monthly rate right? In the selected lecture notes that you have given us, on page 39, why is it FV sir? Should'nt it be PV?

Yes, you are right. The phrases “with monthly compounding” and “compounded monthly” mean the same thing. If an annual rate is given and it is not mentioned that it’s an effective rate, it’s always the annual percentage rate (APR). So, you devide that rate by the number of such periods in a year to get the periodic rate, just like you said. If a periodic rate is mentioned that’s the actual rate for that period.

In the daily compounding problem you are referring to, please notice that the amount $15,000 will be needed after 3 years (FUTURE VALUE) to buy a car and you want to calculate the amount of money you need to deposit today (PRESENT VALUE), so that at 5.5% APR based on a daily compounding it (today's deposit) would grow to your desired amount after 3 years.