Capital Budgeting (W2-4) Flashcards

1
Q

NPV Minimum Acceptance Criteria

A

Accept if NPV > 0

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2
Q

NPV Ranking Criteria

A

Choose highest NPV

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3
Q

Why use NPV? (2)

A

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

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4
Q

What is the IRR

A

Internal Rae of Return - sets NPV to zero

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5
Q

IRR Minimum Acceptance Criteria

A

Accept if IRR exceeds Required Rate of Return

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6
Q

IRR Ranking Criteria

A

Select alternative with highest IRR

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7
Q

What assumption comes with IRR?

A

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

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8
Q

Advantage of IRR

A

Easy to understand

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9
Q

Disadvantages of IRR (4)

A

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

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10
Q

Two types of projects effected by IRR

A

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

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11
Q

Financing vs. Investment Projects

A

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

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12
Q

Three approaches for Modified Internal Rate of Return (MIRR)

A

Discounting
Reinvestment
Combination

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13
Q

Discounting Approach

A

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

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14
Q

Reinvestment Approach

A

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.

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15
Q

Combination Approach

A

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

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16
Q

Independent Project

A

Must exceed a minimum acceptance criteria

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17
Q

Mutually exclusive

A

Rank all alternatives, select the best

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18
Q

Size/Disparity Problem

A

Associated with mutually exclusive projects, initial investments are substantially different

19
Q

Payback Period

A

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

20
Q

Minimum Acceptance Criteria and Ranking Criteria for Payback Period

A

Set by management

21
Q

Advantages of Payback Rule (2)

A

Easy to understand
Biased towards liquidity

22
Q

Disadvantages of Payback Rule (4)

A

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

23
Q

Discounted Payback Period

A

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

24
Q

Decision Rule Discounted Payback Period

A

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

25
Q

Profitability Index

A

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

26
Q

Acceptance Criteria + Ranking Criteria (PI)

A

Accept if PI > 1 or select alternative with highest PI

27
Q

PI Advantages (3)

A

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

28
Q

PI Disadvantage

A

Problems with mutually exclusive projects

29
Q

Depreciation Characteristics (3)

A

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

30
Q

Ways to calculate depreciation (2)

A

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

31
Q

Net Working Capital (3)

A
  • 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).
32
Q

Three major impacts of Tax

A
  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
33
Q

How to calculate operating cash flow? Bottom Up Approach

A

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

34
Q

Opportunity Cost

A

Lost revenue from alternative uses

35
Q

Real vs. Nominal Rate

A

Nominal = current price, real = adjusted for inflation

36
Q

Assumption for Mutually Exclusive Projects with unequal lives

A

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

37
Q

Methods of analysing mutually exclusive projects (3)

A

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

38
Q

Types of Uncertainty (3)

A

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

39
Q

Financial Break even

A

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

40
Q

Financial Option

A

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

41
Q

3 types of options

A

Expand, abandon, delay

42
Q

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

A

Uncertainty
Learning
Flexibility
Irreversibility

43
Q

The market value of a project is…

A

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