Capital Budgetting Flashcards
Capital Budgetting
Evaluate project on CF implications because firm exists to make money for the shareholder
Conventional project
cash outflow followed by inflow
Loan project
cash inflow followed by outflow
Payback
How long it takes for the cash inflows to equal cash outflows
Discounted Payback
where PV of inflows = outflows
NPV
sum of PV of all investment cash flows
NPV > 0
accept
PV inflow > PV outflow
suggests that we cash inflows can offset the cash outflow but still have $ remaining for shareholders
Project earns more than discount rate
NPV and stock price
stock price change: NPV / shares outstanding
Discount rate
opportunity cost for shareholder, what external projects earn
Hurdle rate
synonymous with discount rate
IRR - conventional
return per period if you get projected CFs
discount rate where NPV is 0
IRR > d - accept because NPV is positive
IRR < d - reject, NPV is negative
IRR in bond terms
yield to maturity
Discount rate and risk
high risk high discount rate
risk is the uncertainty of the cash flow
Profitability Index
PV of cash inflow / PV cash outflow
if it is greater than 1, accept the project as it implies high value of cash inflow
Loan Projects (NPV, IRR, etc)
NPV slopes up
y-intercept: sum of project cash flows
Loan - IRR
Cost per period
IRR > d - reject
IRR < d - accept
Loan Discount Rate
return for a given risk
Payback advantage
- Easy to understand
- Provides a control
- Biased towards liquidity
Payback Disadvantage
- Ignores TVM
- Ignores CF beyond payback period
- Biased against long-term projects
Discounted payback period advantage
- Includes TVM
- Easy to understand
- No negative NPV investments / biased to liquidity
Discounted payback period disadvantage
- Reject some good positive NPV projects
- Ignores CF beyond the cutoff date
- Biased against long term projects
AAR Advantages
- Easy calculation
2. Have requisite info
AAR Disadvantages
- No TVM
- Doesn’t use CFs
3, Arbitrary cutoff date
Profitability Index Advantages
- Related to NPV
- Intuitive aspect
- Good in times of low funds
Profitability Index Disadvantage
Similar to IRR can be misleading and make you pick wrong investment
IRR Disadvantage
- Same project can have multiple IRRs
- Need to choose a hurdle / discount rate
- Can’t be used for mutually exclusive projects
- Adds nothing to NPV
IRR Advantage
Intuitive aspect and uses TVM
