Chap 5 Flashcards
When a financial manager has cash on hand, what are their 2 options?
The firm can either keep and reinvest cash or return it to investors.
If cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets.
What percentage of firms use the NPV rule? IRR?
75% roughly use NPV rule
75% roughly use IRR rule
What other 3 ways other than NPV and IRR that you can value an investment?
the project’s payback, its book rate of return, and profitability index
Why is NPV so widely used? What are 3 points to remember?
- Uses time value of money
- Depends on forecasted CF and opportunity C.O.C
- You can add up NPV’s
With NPV, can you be tricked into accepting a package of poor investments over a better, single investment?
NO. but with other measures you can be….
Suppose project B has a negative NPV. If you tack it onto project A, the joint project (A + B) must have a lower NPV than A on its own…
Therefore, you are unlikely to be misled into accepting a poor project (B) just because it is packaged with a good one (A).
What does NPV depend on?
A project’s cash flows and the opportunity cost of capital. NOT book returns (accounting values)
But when companies report to shareholders, they do not simply show the cash flows. They also report book—that is, accounting—income and book assets.
What is the formula for book rate of return?
book income/book assets
How are cash flows and book income different?
The accountant labels some cash outflows as capital investments and others as operating expenses. The operating expenses are, of course, deducted immediately from each year’s income. The capital expenditures are put on the firm’s balance sheet and then depreciated.
The annual depreciation charge is deducted from each year’s income (dep’n exp). Thus the book rate of return depends on which items the accountant treats as capital investments and how rapidly they are depreciated
Why is book rate of return not a good measure of true profitability?
- it is an average across all of the firm’s activities, and the average profitability of past investments is not usually the right hurdle for new investments
What is the payback period? What is the payback rule?
- the payback period is found by counting the number of years it takes before the cumulative cash flow equals the initial investment
- the rule states that a project should be accepted if its payback period is less than some specified (random?) cutoff period
Why is the payback rule not a good measure of true profitability?
- The payback rule ignores all cash flows after the cutoff date
- The payback rule gives equal weight to all cash flows before the cutoff date
Should the same payback period be used for every investment?
No, if it uses the same cutoff regardless of project life, it will tend to accept many poor short-lived projects and reject many good long-lived ones.
Why would the payback rule ever be used?
1) simple to communicate
2) quicker profits, quicker promotion
3) firms who are worried about raising capital in the future
What is the discounted payback rule and how is it computed?
The discounted payback rule asks: How many years does the project have to last in order for it to make sense in terms of net present value?
Computed by: discounting cash flows before payback rule is computed
What are the pros and cons of a discounted payback rule?
PRO: it will never accept a negative-NPV project.
CON: it still takes no account of cash flows after the cutoff date, so that good long-term projects continue to risk rejection.
What is the IRR rule?
Accept project with IRR> C.O.C
How do you calculate true rate of return (IRR) of a single payoff after one period?
return = payoff/investment -1
How do you calculate IRR?
the discount rate that gives a 0 NPV
What is the IRR also known as?
DCF rate of return
When solving for IRR with multiple cash flows, how do you know whether to try a higher or lower rate?
If you get a large NPV, need to try a higher rate (%) to bring the value down.
If you get a negative NPV, you need to try a lower rate(%)
to bring the value back up
In what investment scenario will your IRR be equal to YTM rate?
Bonds if you buy them at market price and hold them to maturity, NPV will be 0 so IRR=YTM
What is the difference between IRR and C.O.C?
IRR: profitability measure that depends solely on the amount and timing of the project cash flows
C.O.C: a standard of profitability that we use to calculate how much the project is worth. It is the expected rate of return offered by other assets with the same risk as the project being evaluated
When will NPV rule and IRR rule give the same result?
whenever the NPV of a project is a smoothly declining function of the discount rate
Explain, Pitfall 1: Lending and Borrowing, of IRR rule
Investment could have higher IRR but if we are borrowing money, this is not an attractive investment….
When we lend money, we want a high rate of return; when we borrow money, we want a low rate of return.
Explain Pitfall 2: Multiple Rates of Return, of IRR rule
there can be as many internal rates of return for a project as there are changes in the sign of the cash flows
this means, with the same set of cash flows, you could have 2 different rates that make NPV=0 if there is 2 sign switches, then which do you pick?
Note: sometimes a project can have no IRR if NPV is always positive
Explain Pitfall 3: Mutually Exclusive Projects (p 115-117 help)
- mutually exclusive projects are alternative ways of doing the same thing, what if one has higher IRR but the other has higher NPV?
- salvage the IRR rule in these cases by looking at the internal rate of return on the incremental flows
- MEANING: First, you check that smaller project has a satisfactory IRR. Then you look at the return on the incremental cash flows from larger investment. Chose between the two by seeing if the IRR on the incremental cash flows was greater or less than C.O.C
What is MIRR?
- a way of getting around multiple rates of return by discounting the later cash flows back at the cost of capital until there remains only one change in the sign of the cash flows
- MIRR is then calculated on this revised series
How is MIRR calculated?
- Calculate PV at time t of all subsequent cash flows
- Add back CF at time t = this gives u IRR (not in percent)
- Revised series will only have 1 sign change, and 1 IRR
If there is a capital constraint, should IRR be used to rank projects?
NO
The choice b/w NPV rule and IRR rule should depend on the probable reinvestment rate. T or F?
NOOOO it shouldn’t.
Should the prospective return on another independent investment ever be allowed to influence the investment decision?
NO, never allow prospective return on another INDEPENDENT investment to influence
Would a not-flat term structure affect IRR? (meaning different C.O.C rates over investment)
No, the IRR usually survives, even when the term structure is not flat.
Where do you typically find the highest IRR’s?
In short-lived projects requiring little up-front investment. But such projects may not add much to the value of the firm
What is capital rationing?
- limitations on the investment program that prevent the company from undertaking all such projects
- when capital is rationed, we need a method of selecting the package of projects that is within the company’s resources yet gives the highest possible net present value
How is the profitability index measured? What is a similar measure?
profitability index = NPV/investment, take highest
benefit cost ratio= PV/investment or 1+profitability index
If a project has a positive profitability index….
it must also have a positive NPV
When can profitability index be misleading or when may it “break down”?
- mutually exclusive projects (dependent)
- more than one resource is rationed
- if it causes some money to be left over; It might be better to spend all the available funds even if this involves accepting a project with a slightly lower profitability index
What is a downfall of linear programming?
assume that all future investment opportunities are known
What is soft rationing?
provisional limits adopted by management as an aid to financial control
-doesn’t cost the firm anything
What is hard rationing?
- firm can’t raise more money
- implies market imperfections
Does a barrier between the firm and capital markets undermine NPV rule?
-no, as long as the barrier is the only market imperfection
When is the NPV undermined?
when imperfections restrict shareholders’ port- folio choice
