chapter 11 - the basics of capital budgeting Flashcards
What is capital budgeting? What is a company’s
strategic business plan?
Capital budgeting- Analysis of potential additions to fixed assets and rates of return
Strategic business plan – a long run plan that outlines in broad terms the firm’s basic strategy for the next 5-10 years
–> Very important to the firm’s future.
What are the five criteria used to accept or
reject a project?
- Net Present Value
- Internal Rate of Return
- Modified internal rate of return (IRR)
- Regular payback
- Discounted payback
→ Net Present Value is the best method
→ Most companies calculate all methods
Know the strengths and disadvantages of each
method
* NPV, IRR, MIRR, Payback, Discounted Payback
- Net Present Value (best - max shareholder value)
- Internal Rate of Return (suffers from defect)
- Modified internal rate of return (IRR) (mirr> irr)
- Regular payback (risk management tools)
- Discounted payback (risk management tools)
What is the crossover rate?
rate in which there is a switch between which project is recommended
Calculating the cross-over rate: just take the difference in the cash flows between 2 projects and find the IRR using financial calculator
What is the difference between independent and
mutually exclusive projects? Which type of
project is harder to calculate?
Independent projects: The cash flows of one project do not impact the cash flows or acceptance of the other project.
Mutually exclusive projects: The cash flows of one project are dependent on the cash flows/acceptance of the other project.
the mutually exclusive projects is harder to calculate
Explain the difference between normal and
nonnormal cash flow streams. Which cash flow
stream is most common? Why?
Normal cash flow stream:
- Initial Cost (negative CF) followed by a series of positive cash inflows. Only one change of signs.
Nonnormal cash flow stream:
- Two or more changes of signs.
- Profitability oscillates back and forth
- Example: oil prices often go up and down significantly, so cash net cash inflow may be negative one year and positive the next
Most projects have normal cash flow streams because its easier to value projects and ball
ON EXAM: How do we calculate a project’s NPV and
how to use NPV decision rules to decide
whether or not to accept the project.
Solving for NPV: Financial Calculator Solution
1. Click the CF button.
2. Clear past cash flows; click 2nd button and CE/C button
3. Enter first C0 cash flow (should be negative) and click enter.
4. Click the down arrow button
5. Enter the frequency of cash flow (typically 1) & click enter
6. Click the down button and enter next cash flow
7. After all cash flows are entered, click NPV or IRR button
8. Enter the interest rate followed by enter button and down arrow button
9. Click the CPT button
ON EXAM: npv decision rules to decide whether or not to accept the project
NPV = PV of inflows – Cost
= Net gain in wealth
If projects are independent, accept if the project NPV > 0.
If projects are mutually exclusive, accept project with the highest positive NPV, one that adds the most value.
In this example, accept S if mutually exclusive (NPVS > NPVL), and accept both if independent.
What is the IRR (internal rate of return?)
irr> wacc = accept project
How do we solve for the IRR and decisions
rules for using IRR to accept or reject a
project.
(1) Know how to plug numbers into the calculator, including if multiple years of same cash flows
(2) Find difference between 2 IRRs (solve for one IRR using calc, solve for 2nd IRR, then subtract difference)
(3) Both IRRs can be negative if you HAVE to choose one of the projects: select the least negative number
(4) Select the Best project - use NPV first, then run IRR
What are the different reinvestment rate
assumptions for the NPV method versus the IRR
method. –> WACC is used for which methods?
Timing differences: The project with faster payback provides more CF in early years for reinvestment. If WACC is high, early CF is especially good, NPVS > NPVL.
Which of the methods is the best (NPV or IRR)?
Why?
NPV
Why is the MIRR a better measure than IRR?
* What is IRR’s main issues?
MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC.
MIRR assumes reinvestment at the opportunity cost = WACC. MIRR also avoids the multiple IRR problem.
Managers like rate of return comparisons, and MIRR is better for this than IRR.
MIRR IS A 2-STEP PROCESS TO SOLVE! (We will use constant cash flows to make this problem reasonable to solve using calculator)
1. Get the FV of the cash flows using financial calculator
2. Find the I/YR using the calculator.
What is the payback period? Why do companies
often calculate this measure despite its
problems? Discuss its strengths and
weaknesses.
The number of years required to recover a project’s cost, or “How long does it take to get our money back?”
Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.
Calculating payback:
1. Constant cash flows – simple division
2. Nonconstant cash flows – create a table of cumulative cash flows until turn positive.
What is the payback period of a $100,000 initial project that produces $15,000 for 10 years?
Constant cash flows, so you can simply divide
100,000 / 15,000 = 6.666666 years
