Financial Management Ass.01

Financial Management
Assignment 01
Instructor - Abreham Amanuel (PhD)
Summited by: Eyob Fisseha

ID: MBAO/15A/5452
1. What is simple interest? What is compound interest and its importance?
Interest is what you pay to paid to a lender when you borrow money. Interest
is also what a bank pays you when you put money in savings account or CD.
The interest rate is usually shown as a percentage.
Interest can be calculated in two ways: simple interest or compound interest.

Simple interest is calculated on the principal, or original, amount of a loan.
Compound interest is calculated on the principal amount and the accumulated
interest of previous periods, and thus can be regarded as “interest on interest.”
2. What is an annuity? Is an annuity worth more or less than a lump sum

payment received now that would equal the sum of all the future annuity
payments.
An annuity is a financial product that provides a series of regular payments
over a specified period of time. It is commonly used for retirement planning or
to provide a steady income stream.
An annuity can be worth more or less than a lump sum payment received now,
depending on various factors such as interest rates, inflation, and individual
circumstances. Here are two scenarios to consider:
Annuity worth more: If the annuity offers a higher rate of return than the lump
sum payment would earn if invested elsewhere, the annuity may be worth
more. This is especially true if the annuity payments are guaranteed and
provide a stable income stream.
Lump sum worth more: If the lump sum payment can be invested at a higher
rate of return than the annuity offers, it may be worth more. Additionally, if
there is a need for a large sum of money upfront..
3. The payback period method has been criticized for not taking the time value
of money into account. Could this limitation be overcome? If so, would this
method then be preferable to the NPV method?
The payback period method is criticized for not considering the time value of
money, which is the concept that money received in the future is worth less
than money received today. However, this limitation can be overcome by using
the discounted payback period method.
The discounted payback period method adjusts the cash flows by discounting
them to their present value using an appropriate discount rate. By
incorporating the time value of money, this method provides a more accurate
measure of the profitability of an investment.
While the discounted payback period method addresses the limitation of not
considering the time value of money, it still has some drawbacks. It does not
provide a clear indication of the profitability of an investment compared to a
specific benchmark or hurdle rate. Additionally, it does not consider cash flows
beyond the payback period.
On the other hand, the net present value (NPV) method takes into account the
time value of money by discounting all cash flows to their present value and
subtracting the initial investment. It provides a more comprehensive measure
of the profitability of an investment and considers cash flows throughout the
project's life.
In conclusion, while the payback period method can be improved by using the
discounted payback period method, the NPV method is generally considered
more preferable due to its ability to consider the time value of money and
provide a more comprehensive evaluation of an investment's profitability.
4. Research indicates that the IRR method is extremely popular even though it
has shortcomings when compared to the NPV method. Why might managers
prefer to use IRR rather than NPV when carrying out discounted cash flow
evaluations?
Managers may prefer to use the Internal Rate of Return (IRR) method over the
Net Present Value (NPV) method for discounted cash flow evaluations due to
several reasons:
Simplicity: The IRR method provides a single percentage rate of return, which
is easier for managers to understand and communicate compared to the NPV
method, which requires calculating the present value of cash flows.
Intuitive decision-making: The IRR method focuses on the rate of return

generated by an investment, which aligns with managers' intuition of
evaluating projects based on their profitability. Managers may find it more
intuitive to compare projects based on their IRRs rather than the absolute
dollar value of NPV.
Emphasis on liquidity: The IRR method considers the time value of money and
the cash flow timing, which is important for managers who prioritize liquidity
and cash flow management. By focusing on the rate of return, the IRR method
highlights the speed at which an investment generates cash flows.
Considers reinvestment: The IRR method implicitly assumes that cash flows
generated by an investment are reinvested at the same rate of return. This
assumption may align with managers' expectations of reinvesting cash flows
into similar projects, making the IRR method more appealing.
Psychological bias: The IRR method often yields higher rates of return
compared to the cost of capital, which can be psychologically appealing to
managers. This bias towards higher rates of return may influence their
preference for the IRR method.
However, it is important to note that the IRR method has limitations, such as
potential multiple IRRs, inability to handle mutually exclusive projects, and
reliance on accurate cash flow estimates. Therefore, managers should consider
using both the IRR and NPV methods together to make more informed
investment decisions.
5. How might excessively high levels of borrowing adversely affect the ability of
managers to run the business?
Excessively high levels of borrowing can have several adverse effects on a
business and its ability to be effectively managed. Here are some ways in which
excessive borrowing can impact managers and the business:
Financial burden: High levels of borrowing result in increased interest

payments and debt servicing costs. This can strain the company's cash flow
and limit its ability to invest in growth opportunities, research and
development, or other essential activities. Managers may find it challenging to
allocate resources effectively and make strategic decisions due to limited
financial flexibility.
Increased risk: Excessive borrowing increases the company's financial risk. If

the business is unable to generate sufficient cash flow to meet its debt
obligations, it may face default or bankruptcy. Managers must navigate the
increased risk and uncertainty associated with high debt levels, which can
hinder their ability to make long-term plans and investments.
Reduced profitability: High levels of borrowing can lead to higher interest
expenses, which directly impact the company's profitability. Managers may
need to allocate a significant portion of the company's earnings towards debt
repayment, leaving fewer resources available for reinvestment or distribution to
shareholders. This can limit the company's ability to generate profits and grow
over time.
Limited access to additional funding: Excessive borrowing can negatively

impact the company's creditworthiness and make it more challenging to secure
additional funding in the future. This can restrict the company's ability to
obtain loans or issue bonds, limiting its options for financing growth or
managing unforeseen events.
Loss of control: In some cases, excessive borrowing may require the company
to seek external financing from investors or lenders. This can result in dilution
of ownership or the need to give up control to external parties. Managers may
face pressure from these stakeholders, impacting their ability to make
independent decisions and pursue long-term strategies.

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Financial Management

Summited by: Eyob Fisseha

1. What is simple interest? What is compound interest and its importance?

Interest can be calculated in two ways: simple interest or compound interest.

2. What is an annuity? Is an annuity worth more or less than a lump sum

Intuitive decision-making: The IRR method focuses on the rate of return

Financial burden: High levels of borrowing result in increased interest

Increased risk: Excessive borrowing increases the company's financial risk. If

Limited access to additional funding: Excessive borrowing can negatively

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