Chapter 10 Flashcards
capital
long term assets used in production
budget
a plan that outlines projected expenditures during a future period
capital budgeting
the whole process of analyzing projects and deciding which ones to accept and thus include in the capital budget
differences in security valuation and capital budgeting
stocks and bonds exist in the secuurities markets and investors chose from available set, most investors have no influence over the cash flows produced by their investments
Net Present Value
the present value of a projects cash inflows minus the present value of its costs, tells us how much the project contributes to shareholder wealth.
Larger NPV means
the more value the project adds and the higher the stock price
independent projects
those whose cash flows are not affected by other projects
mutually exclusive projects
two different ways of accomplishing the same result, so if one is accepted the other must be rejected
Internal Rate of Return
the discount rate that forces the PV of the inflows to equal the initial cost. the is equivalent to forcing NPV to zero. an estimate of the project’s rate of return, similar to ytm on a bond
Multiple Internal Rates of Return
if a project has nonnormal cash flwos (more than one sign change) then it has multiple IRRs.
Assumption of the NPV calculation
cash inflows can be reinvested at the projects WACC
IRR assumption
cash flows can be reinvested at the IRR
Why is assuming reinvestment at the WACC better
firms with good investments usually have access to debt and equity markets and can raise all of the capital it needs at the going rate, the WACC
problem with the IRR
overstates the expected return for accepted projects because cash flows cannot generally be reinvested at the IRR itself
Modified IRR (MIRR)
similar to the IRR but assumes that cash flows are reinvested at the WACC
advantages of MIRR over IRR
IRR assumes cash flows are reinvested at IRR, MIRR assumes reinvestment at COC, so MIRR is a better gauge of profitability. MIRR eliminates Multiple IRR problem
Is MIRR as good as NPV?
for indpendent projects NPV, IRR, MIRR will reach same coclusion. for mutually exclusive, NPV is best
Net Present Value Profile
find the project’s NPV at a number of different discount rates and then plan those values to create a graph
crossover rate
where to npv profile lines cross, conflict if WACC is to the left, no conflict if to the right
What happens to NPV when COC increases
if cash flows happen in later years, sharp decline in npv. earlier cash flows not severely effected
Profitability Index
shows the relative profitability of any project, or the present value per dollar of initial cost
payback period
the number of years required to recover the funds invested in a project from its operating cash flows
three flaws with regular payback
- dollars received in different years all given the same weight, no time value considered 2. cash flows beyond payback year given no consideration 3. unlike npv and irr, there is no link back to investor welath gaines from the project
discounted payback
cash flows are discounted at the WACC and then used to find the payback
When should we worry about analysis of unequal lives
when looking at mutually exclusive projects with unequal lives
economic life
the life that maximizes npv and thus shareholder wealth
physical or engineering life
number of years of project
optimal capital budget
the set of projects that maximizes the value of the firn
complications of optimal capital budget
- coc might increase as size of budget increase making it hard to know proper discount rate to use 2. firms may set an upper limit to size of capital budgets
capital rationing
reluctance to issue new stock, constraints on nonmonetary resources-may not have resources to accept all projects that look good. controlling estimation bias-make management use unralistically high coc in estimations to limit bias
