Capital Budgeting (W2-4)

Question 1

NPV Minimum Acceptance Criteria

Answer 1

Accept if NPV > 0

Question 2

NPV Ranking Criteria

Answer 2

Choose highest NPV

Question 3

Why use NPV? (2)

Answer 3

Uses all the cash flows of the project
Discounts the cash flows

Question 4

What is the IRR

Answer 4

Internal Rae of Return - sets NPV to zero

Question 5

IRR Minimum Acceptance Criteria

Answer 5

Accept if IRR exceeds Required Rate of Return

Question 6

IRR Ranking Criteria

Answer 6

Select alternative with highest IRR

Question 7

What assumption comes with IRR?

Answer 7

Reinvestment Assumption - all future cash flows are assumed to be reinvested at the IRR

Question 8

Advantage of IRR

Answer 8

Easy to understand

Question 9

Disadvantages of IRR (4)

Answer 9

Does not distinguish between investing and borrowing
IRR may not exist
Multiple IRRs
Problems with mutually exclusive investments.

Question 10

Two types of projects effected by IRR

Answer 10

Investment Project - negative cash flows are frontloaded, higher discount rate erodes NPV, invest if IRR > Hurdle

Financing Project - negative cash flows are backloaded, high discount rates increase NPV, invest if IRR < Hurdle Rate

Question 11

Financing vs. Investment Projects

Answer 11

Investment - conventional, pay to invest in something that generates cash later on.
Financing - receive today, pay back later

Question 12

Three approaches for Modified Internal Rate of Return (MIRR)

Answer 12

Discounting
Reinvestment
Combination

Question 13

Discounting Approach

Answer 13

Discount all negative cash flows back to year zero and add them to initial cost

Question 14

Reinvestment Approach

Answer 14

Compound any cash flows except for the first out to the end of the project, not taking any cash out until the end of the life.

Question 15

Combination Approach

Answer 15

Both discounting negative CFs to year 0 and compounding all other CFs to the end of the project.

Question 16

Independent Project

Answer 16

Must exceed a minimum acceptance criteria

Question 17

Mutually exclusive

Answer 17

Rank all alternatives, select the best

Question 18

Size/Disparity Problem

Answer 18

Associated with mutually exclusive projects, initial investments are substantially different

Question 19

Payback Period

Answer 19

How long does it take the project to pay back its inital investment?

Question 20

Minimum Acceptance Criteria and Ranking Criteria for Payback Period

Answer 20

Set by management

Question 21

Advantages of Payback Rule (2)

Answer 21

Easy to understand
Biased towards liquidity

Question 22

Disadvantages of Payback Rule (4)

Answer 22

Ignores TVM
Ignores CFs after payback period
Biased against long term projects
Project accepted based on payback criteria may not have a positive NPV.

Question 23

Discounted Payback Period

Answer 23

How long it takes to payback initial investment taking TVM into account

Question 24

Decision Rule Discounted Payback Period

Answer 24

Accept if it pays back on a discounted basis within then specified time

Question 25

Profitability Index

Answer 25

Ratio between the present value of future expected cash flows and the initial amount invested in the project

Question 26

Acceptance Criteria + Ranking Criteria (PI)

Answer 26

Accept if PI > 1 or select alternative with highest PI

Question 27

PI Advantages (3)

Answer 27

Useful when investment funds are limited Easy to understand and communicate Correct decision when evaluating individual projects

Question 28

PI Disadvantage

Answer 28

Problems with mutually exclusive projects

Question 29

Depreciation Characteristics (3)

Answer 29

Not a real cash flow A tax shelter and tax savings Depreciation affects CF positively by reducing taxable income

Question 30

Ways to calculate depreciation (2)

Answer 30

Straight line - initial asset cost divided by number of useful years. Diminishing balance - constant rate applied to the asset's beginning of year book value to identify deduction each year

Question 31

Net Working Capital (3)

Answer 31

- WC is cash employed to run day-to-day operations, not consumed but rather employed for a period of time - Increase in WC during a period means more cash is employed, vice versa. - WC normally assumed to be recovered at the end of the project (terminal year).

Question 32

Three major impacts of Tax

Answer 32

1. Income tax represents cash outflow 2. Tax shield 3. Capital gains tax - lowers proceeds made from sale of an asset. capital loss may result in a tax saving

Question 33

How to calculate operating cash flow? Bottom Up Approach

Answer 33

OCF = (R - C - D)(1-tc) + D

Question 34

Opportunity Cost

Answer 34

Lost revenue from alternative uses

Question 35

Real vs. Nominal Rate

Answer 35

Nominal = current price, real = adjusted for inflation

Question 36

Assumption for Mutually Exclusive Projects with unequal lives

Answer 36

Replication at the end of a projects life w/ a replacement (identical)

Question 37

Methods of analysing mutually exclusive projects (3)

Answer 37

Lowest common life NPV in perpetuity - preferred method Equivalent Annual Annuity - assumes project will be repeated

Question 38

Types of Uncertainty (3)

Answer 38

Direct - Binary (significant government or competitor investment, etc.) Direct - Diffuse (consumer demand, etc.) Indirect (financial markets and access to capital, etc.)

Question 39

Financial Break even

Answer 39

Sales volume that generates a NPV of zero - Use II equation & PVIFA

Question 40

Financial Option

Answer 40

Owner has the right but not the obligation to buy something in the future for a price set today

Question 41

3 types of options

Answer 41

Expand, abandon, delay

Question 42

4 things that need to be true for option values to exist in real investment analysis

Answer 42

Uncertainty Learning Flexibility Irreversibility

Question 43

The market value of a project is...

Answer 43

The sum of the NPV of the project without options and the value of the managerial options implicit in the project. MV = NPV + option value