Chapter 11 Flashcards
refers to long term assets used in production
capital
plan that outlines projected expenditures during some future period
budget
summary of planned investment in long term assets
capital budget
process of planning expenditures on assets with cash flows that are expected to extend beyond 1 year
capital budgeting
capital budgeting uses same concepts used in
security valuation
stocks and bond exist in the security markets, and investors select from the available set
investors have no influence on the cash flows produced by their investments
security valuation
firms, create capital budgeting projects
corporations have major influence on projects’ results
capital budgeting
similarities of stock valuation and capital budgeting
- forecast set of cash flows
- find the present value of those flows
- pv of the inflows > investment’s cost
criteria for deciding to accept or reject projects
- Net present value
- Internal Rate of return
- modified internal rate of return
- regular payback
- discounted payback
a method of ranking investment proposals using the npv, which is equal ro the pv of future net cash flows, discounted at the cost of capital
NPV
tells how much a project contributes to shareholder wealth
NPV
high discount rate will lead to __ NPV
lower
larger NPV = ____ project adds
more value
NPV FORMULA
NPV = CF0 + CFN / (1+r )^N
types of decision rules
- independent projects
- mutually exclusive projects
projects whose cash flows are note affected by one another
independent project
independent projects
NPV > 0 => Accept
projects where if one project is accepted, the other must be rejected
Mutually exclusive projects
mutually exclusive projects accept
- highest positive NPV
- if no project is positive - reject all
it is the discount rate that forces the pv of inflows to equl the cost. (npv = 0)
internal rate of return
if IRR>cost of fund
difference will be a bonus to a stockholders and cause stock price to rise
independent projects accept
IRR > WACC
mutually exclusive project accept
project with highest IRR
a graph showing the relationship between a project’s NPV and fhe firm’s cost of capital
NPV Profiles
npv profiles x and y axes
x axis - discount rate
y axis - NPV
the rate of return at which rhe NPVs of two projects are equal
crossover rate
useful in capital budgeting analysis because it tells the investing company about the cost of capital at which both of the mutually exclusive projects are equally good
npv profiles
limitations of IRR
- unconventional cash flows
- reinvestment assumption
(npv calculation is based on the assumption that cash inflows can be reinvested at the projects risk adjusted wacc
assumes that positive cash flows are reinvested at the firm’s cost of capital and that negative cash flows are financed at the firm’s financing cost
MIRR
MIRR FORMULA
[nth root of FV (reinvestment rate)/ -PV (finance cost)] - 1
evaluating true ratw of return
MIRR > IRR
choosing among competing projects
NPV > IRR and MIRR
the length of time required for an investment’s net revenues to cover its cost
payback period
payback formula
no. of years prior to full recovery + (unrecovered cost at start of year/CF during full recovery)
assumes unifoem CF
payback note
shorter the payback, better the project
advantages of payback period
- easy to understand
- adjust for uncerrainy of later CF
- biased towards liquidity
disadvantages if payback period
- ignores time value of money
- requires an arbitrary cutoff point
- ignores cf beyond the cutoff date
- biased against long term projects, such as research and development, and new projects
the length of time required for an investment’s cash flows, discounted at the investment’s cost of capital, to cover its costs
discounted payback
it is used as part of capital budgeting to determine which projects to take on
discounted payback
more accurate because discounted payback period factors in the
time value of money
accept/reject decisions, large, sophisticated firms
all five measures
provides direct measure of value the project adds to shareholder wealth
NPV
measure profitability
IRR and MIRR
contain information concerninf project’s safety margin
percentage rate of return
is better indicator to know projects’ rates if return
MIRR
provide indications if project’s liquidity and risk
payback and discounted payback
means relatively illiquid and riskier than one with a shorter payback
long payback
it is the best single criterion, but all of the methods provide useful information and all are easy to calculate, thus all are used along with judgement and common sense
NET PRESENT VALUE
