Chapter 11 - The Basics of Capital Budgeting Flashcards
What is a method of analyzing and comparing substantial future investments and expenditures to determine which ones are most worthwhile?
Capital budgeting
What is the number of years required to recover a project’s cost?
The payback period
What is the formula to calculate the payback period if the cumulative cash flow doesn’t equal 0?
current year + (current year’s cummulative cash flow / next year’s cash flow)
Solve the problem:
Year 0 CF = (10,000) Year 1 CF = 2,000 Year 2 CF = 5,000 Year 3 CF = 3,000 Year 4 CF = 2,000
Calculate the payback period
Y0 CCF = (10,000)
Y1 CCF = (8,000)
Y2 CCF = (3,000)
Y3 CCF = 0
Payback Period = 3 years
Solve the problem:
Year 0 CF = (10,000) Year 1 CF = 2,000 Year 2 CF = 5,000 Year 3 CF = 2,000 Year 4 CF = 2,000
Calculate the payback period
Y0 CCF = (10,000)
Y1 CCF = (8,000)
Y2 CCF = (3,000)
Y3 CCF = (1,000)
PP = 3 + (1,000/2,000) PP = 3.5 years
Should you choose the project with a shorter or longer payback period?
A shorter payback period
We have the 2 following projects, which one should we choose?
Project A PP = 2.5 years
Project B PP = 3.2 years
Project A
List the 3 weaknesses of the payback period
- It ignores the time value of money
- It ignores CFs occurring after the payback period
- There is no relationship between a given payback and the investor wealth maximization
List the 3 steps to calculate the discounted payback period
- Calculate the discounted cash flow
- Calculate the cumulative cash flow
- Calculate the discounted payback period
What is the discounted cash flow equal to?
PV
Which calculator buttons do you use to calculate the discounted cash flow?
N, I, FV, PV
When you are calculating the discounted payback period do you subtract the cash flow or the discounted cash flow from the cumulative cash flow?
The discounted cash flow
Solve the problem:
WACC = 12% Year 0 CF = (10,000) Year 1 CF = 2,000 Year 2 CF = 3,000 Year 3 CF = 5,000 Year 4 CF = 2,000 Year 5 CF = 2,000
Calculate the discounted payback period
Y0 DCF = (10,000) Y1 DCF = 1,787.71 Y2 DCF = 3,985.97 Y3 DCF = 2,135.34 Y4 DCF = 1,271.04 Y5 DCF = 1,134.85
Y0 CCF = (10,000) Y1 CCF = (8,214.29) Y2 CCF = (4,228.32) Y3 CCF = (2,092.98) Y4 CCF = (821.94)
DPP = 4 + (821.94/1,134.85) DPP = 2.6875 years
What is the sum of all future cash flows?
Net Present Value
What does it mean when the NPV value is positive?
We are gaining money
What does it mean when the NPV value is negative?
We are losing money
Should we accept a project that has a positive NPV?
Yes
Should we accept a project that has a negative NPV?
No
What 2 calculator buttons that you use to calculate NPV?
CF and NPV
Solve the problem:
WACC = 12% Year 0 CF = (10,000) Year 1 CF = 2,000 Year 2 CF = 5,000 Year 3 CF = 3,000 Year 4 CF = 2,000
- Calculate NPV
- Should we accept this project?
- NPV = -821.94
2. No
Solve the problem:
WACC = 12% Year 0 CF = (10,000) Year 1 CF = 5,000 Year 2 CF = 2,000 Year 3 CF = 3,000 Year 4 CF = 4,000
- Calculate NPV
- Should we accept this project?
- NPV = 736.09
2. Yes
Which of the following projects should we accept if both of them are mutually exclusive?
Project A NPV = 200
Project B NPV = 300
Project B
Which of the following projects should we accept if both of them are independent and the firm has enough capital?
Project A NPV = 200
Project B NPV = 300
Both
Which of the following projects should we accept if both of them are mutually exclusive?
Project A NPV = -200
Project B NPV = -300
Nether
Which of the following projects should we accept if both of them are independent and the firm has enough capital?
Project A NPV = -200
Project B NPV = -300
Neither
True or False:
You should never accept a project that has a negative NPV
True
Should you accept the project with the smaller or larger NPV?
The larger NPV
What is the relationship between WACC and NPV the same as?
The relationship between PV and I(YTM)
What happens to NPV when WACC increases?
It decreases
Fill in the Blank: Increase/Decrease
If WACC increases, NPV _______
Decreases
Fill in the Blank: Increase/Decrease
If WACC decreases, NPV _______
Increases
What is the interest rate that makes NPV = 0?
The internal rate of return (IRR)
Which calculator buttons do you use to calculate IRR?
CF and IRR
Solve the problem:
WACC = 12% Year 0 CF = (10,000) Year 1 CF = 5,000 Year 2 CF = 2,000 Year 3 CF = 3,000 Year 4 CF = 4,000
Calculate NPV
NPV = 736.09
Is a larger or smaller IRR value better?
Larger
Is NPV positive or negative when WACC < IRR?
It’s positive
Is NPV positive or negative when WACC > IRR?
It’s negative
Should you accept or reject a project when WACC < IRR?
Accept
Should you accept or reject a project when WACC > IRR?
Reject
Solve the problem:
WACC = 14% Year 0 CF = (10,000) Year 1 CF = 5,000 Year 2 CF = 2,000 Year 3 CF = 3,000 Year 4 CF = 4,000
- Calculate IRR
- Is NPV positive or negative
- Should you accept or reject this project?
- IRR = 15.6198
- Positive
- Yes
Should you accept a project with the following values?
WACC = 16% IRR = 15.6198%
No
What is the formula to calculate WACC?
Weight of debt x cost of debt(1-tax) + weight of equity x cost of equity
Solve the problem:
The company has a target capital structure of 35% debt and 65% common equity. It’s before-tax cost of debt is 8%, and it’s tax rate is 25%. P(0) = 22, D(0) = 2.25, g = 5%, and CoE = 15.74%.
What is the company’s WACC?
WACC = Weight of debt x cost of debt(1-tax) + weight of equity x cost of equity WACC = [0.35 x 0.08 x (1 - 0.25)] + (0.65 x 0.1574) WACC = 12.33%
Fill in the Blank: Increase/Decrease
If Cost of debt increases, WACC _______
Increases
Fill in the Blank: Increase/Decrease
If Cost of equity increases, WACC _______
Decreases
Fill in the Blank: Increase/Decrease
If beta increases, WACC _______
Increases
Do managers prefer the IRR method or the NPV method?
The IRR method
True or False:
One advantage of the payback method for evaluating potential investments is that it provides information about a project’s liquidity and risk.
True
True or False:
The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.
False
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. A project’s NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.
b. The lower the WACC used to calculate it, the lower the calculated NPV will be.
c. If a project’s NPV is less than zero, then its IRR must be less than the WACC.
d. If a project’s NPV is greater than zero, then its IRR must be less than zero.
e. The NPV of a relatively low-risk project should be found using a relatively high WACC.
c. If a project’s NPV is less than zero, then its IRR must be less than the WACC.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. A project’s regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.
b. A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR.
c. If a project’s IRR is smaller than the WACC, then its NPV will be positive.
d. A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
e. If a project’s IRR is positive, then its NPV must also be positive.
d. A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
Which of the following statements is CORRECT?
a. If a project has “normal” cash flows, then its IRR must be positive.
b. If a project has “normal” cash flows, then its MIRR must be positive.
c. If a project has “normal” cash flows, then it will have exactly two real IRRs.
d. The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life.
e. If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR.
e. If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR.
Which of the following statements is CORRECT?
a. Projects with “normal” cash flows can have only one real IRR.
b. Projects with “normal” cash flows can have two or more real IRRs.
c. Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more than two sign changes, then the cash flow stream is “nonnormal.”
d. The “multiple IRR problem” can arise if a project’s cash flows are “normal.”
e. Projects with “nonnormal” cash flows are almost never encountered in the real world.
a. Projects with “normal” cash flows can have only one real IRR.
Which of the following statements is CORRECT?
a. The regular payback method recognizes all cash flows over a project’s life.
b. The discounted payback method recognizes all cash flows over a project’s life, and it also adjusts these cash flows to account for the time value of money.
c. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today.
d. The regular payback is useful as an indicator of a project’s liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.
e. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.
d. The regular payback is useful as an indicator of a project’s liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
c. If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.
b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
Which of the following statements is CORRECT?
a. The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period.
c. If a project’s payback is positive, then the project should be accepted because it must have a positive NPV.
d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
e. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.
b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period.
Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
a. A project’s IRR increases as the WACC declines.
b. A project’s NPV increases as the WACC declines.
c. A project’s MIRR is unaffected by changes in the WACC.
d. A project’s regular payback increases as the WACC declines.
e. A project’s discounted payback increases as the WACC declines.
b. A project’s NPV increases as the WACC declines.
Which of the following statements is CORRECT?
a. For a project to have more than one IRR, then both IRRs must be greater than the WACC.
b. If two projects are mutually exclusive, then they are likely to have multiple IRRs.
c. If a project is independent, then it cannot have multiple IRRs.
d. Multiple IRRs can occur only if the signs of the cash flows change more than once.
e. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.
d. Multiple IRRs can occur only if the signs of the cash flows change more than once.
Which of the following statements is CORRECT?
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. If Project A has a higher IRR than Project B, then Project A must have the lower NPV.
b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
c. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC.
d. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business.
e. If a project has normal cash flows and its IRR exceeds its WACC, then the project’s NPV must be positive.
e. If a project has normal cash flows and its IRR exceeds its WACC, then the project’s NPV must be positive.
Which of the following statements is CORRECT?
a. The MIRR and NPV decision criteria can never conflict.
b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be.
c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.
d. The higher the WACC, the shorter the discounted payback period.
e. The MIRR method assumes that cash flows are reinvested at the crossover rate.
c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows.
a. A project’s MIRR is always greater than its regular IRR.
b. A project’s MIRR is always less than its regular IRR.
c. If a project’s IRR is greater than its WACC, then its MIRR will be greater than the IRR.
d. To find a project’s MIRR, we compound cash inflows at the regular IRR and then find the discount rate that causes the PV of the terminal value to equal the initial cost.
e. To find a project’s MIRR, the textbook procedure compounds cash inflows at the WACC and then finds the discount rate that causes the PV of the terminal value to equal the initial cost.
e. To find a project’s MIRR, the textbook procedure compounds cash inflows at the WACC and then finds the discount rate that causes the PV of the terminal value to equal the initial cost.
Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. Both projects have a cost of capital of 12 percent. Which of the following statements is most correct?
a. Both projects have a positive net present value (NPV).
b. Project A must have a higher NPV than Project B.
c. If the cost of capital were less than 12 percent, Project B would have a higher IRR than Project A.
d. Statements a and c are correct.
e. All of the statements above are correct.
a. Both projects have a positive net present value (NPV).
Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the same risk. Which of the following statements is most correct?
a. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project B will exceed the NPV of Project A.
b. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A.
c. If the WACC is less than 18 percent, Project B will always have a shorter payback than Project A.
d. If the WACC is greater than 18 percent, Project B will always have a shorter payback than Project A.
e. If the WACC increases, the IRR of both projects will decline.
b. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A.
Project A has a higher IRR while Project B has a higher NPV. Which project should you choose?
Project B
What is IRR equal to when there are equal cash flows each year?
I
Solve the problem:
The capital budgeting director of Sparrow Corporation is evaluating a project that costs $200,000, is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm’s cost of capital is 14 percent and its tax rate is 40 percent, what is the project’s IRR?
N = 10 PV = -200,000 PMT = 44,503 I = 18
IRR = 18%
