Capital Budgeting Flashcards
What is the formula for the payback period?
Initial investment / After tax annual net cash flows =
Length of time to recover investment
What is the formula for IRR?
Investment / Annual cash flows = PV factor
Discount rate where NPV = 0
What is the formula for ARR?
Accounting income / Average investment = ROI
What is the formula for NPV?
PV cash inflows using cost of capital rate (hurdle rate)
- PV cash outflows
= NPV
(+) = good (-) = bad
What are advantages and disadvantages of payback period?
A - easy to understand
D - does not take into account time value of money
What are advantages and disadvantages of IRR?
A - takes into account time value of money, takes into account investments with similar risk, more understandable than NPV
D - some cash flows may yield multiple IRRs, some may not have IRR that NPV = 0
What are the advantages and disadvantages of ARR?
A - easy to understand
D - does not take into account time value of money, does not account for different risk, different depreciation methods yield different ARRs
What are advantages and disadvantages of NPV?
A - takes into account time value of money, takes into account risk, takes into account total profitability, yield results in dollars
D - more complex, some may not understand, does not take into account managers not following scheduled cash flows
What is the relationship between IRR and NPV?
NPV > 0, IRR > discount or hurdle rate
NPV = 0, IRR = discount or hurdle rate
NPV < 0, IRR < discount or hurdle rate
What is the profitability index?
Ratio of PV of cash inflows to initial cost of project, used to decide which project to invest in first
PV annual after-tax cash flows / Original investment
Index > 1 is good
What is the formula for annual financing costs?
AFC =
Discount % / (100% - Discount %)
x
365 or 360 / (Total pay period - Discount period)
What is the formula to calculate the cost of a loan?
Interest paid / (Principal - Compensating balance)
What are examples of positive debt covenants?
Provide annual audited F/S
Maintain certain financial ratios
Maintain life insurance for key employees
What are examples of negative debt covenants?
Not borrowing additional sums
Not selling certain assets
Not exceeding certain levels of dividend payments
Not exceeding compensation limits
What is the formula for the current yield?
Annual interest paid / Bond market price
What is the formula for the effective annual interest rate?
EAR = (1 + r/m) m power - 1
r = stated interest rate m = compounding frequency
What are advantages of debt financing?
Tax deductible Fixed payment Do not give up control Excess earnings go to owners Lower issue costs During inflation debt paid back with less valuable dollars
What are disadvantages of debt financing?
Pre-determined payments
Lose flexibility due to covenants
High debt increases risk
What are advantages of C/S financing?
Flexibility in amount of dividend
Less risk
Attractive to investors
What are disadvantages of C/S financing?
Higher issue costs
Ownership dilution with new issues
Not tax deductible
Results in higher cost of capital
What are advantages of P/S financing?
Flexibility to skip dividends
Less risk
C/S holders do not give up control
Company usually keeps excess earnings
What are disadvantages of P/S financing?
Higher issue costs
Not tax deductible
Issues with dividends in arrears
What is the Degree of Operating Leverage?
Measures how the size of a business’s fixed costs affects its performance when revenues change
DOL = % change in EBIT / % change in sales volume
What is the Degree of Financial Leverage?
Measures how much a business relies on debt financing
DFL = % change in EPS / % change in EBIT
