Chapter 8 Flashcards
Chapter 8 focuses on making what decisions?
Investment
A specific decision making process that involves whether or not to proceed with a project
Capital Budgeting
Capital Budgeting involves what and what measurements?
Quantitative and Qualitative
Capital budgeting works by knowing the initial cost and estimating the future what?
Costs and Benefits
1 Define the decision and related issues
2 determine criteria to evaluate alternatives
3 generate alternatives
4 analyze and assess alternatives
5 decide and implement
The Decision Making Framework
1 payback method
2 net present value
3 internal rate of supportive return (IRR)
The 3 Capital Budgeting Techniques
1 for projects with up front investment and smooth or annual cash flows
2 a more general estimation of payback when net cash flows are uneven
The 2 Versions of the Payback Method
Initial Investment / Annual Net Cash Inflow
The Payback Period Formula
The payback method ignores the what of money? Although this is okay for SMALL investments
Time Value
Year Net Cash Flow Cumulative Cash Flow
0 (100) (100)
1. (10). (110)
2. 5 (105)
3. 12. (93)
4. 18. (75)
5. 22. (53)
6. 27. (26)
7. 33. 7
8. 35. 42
Payback Method with Uneven Cash Flow Table
1 easy calculation
2 quick measure of risk
Strengths of the Payback Method
1 no time value consideration
2 no consideration of cash flows expected to occur beyond payback period
Weaknesses of the Payback Method
The goal of the net present value method is to determine what?
The net value added to a firm by the project
The cost of capital in the net present value method formula includes what?
Discount Rates
The risk associated with uncommon territory for the organization is called what?
The Hurdle Rate
A firm should accept any project with a net present value greater than or equal to 0
Net Present Value Rule
— Co + [ C1 / (1 + r) ]
— Co = Initial Cash Outflow Today
Ct = Initial Cash Outflow Today
r = Disc. Or Hurdle Rate as Decimal
The NPV Formula
1 accounts for time value
2 reasonably assumes any interim cash flow from project are reinvested at firm’s cost of capital
The Strengths of the NPV Method
1 challenges in determining realistic cash flow estimate and estimating an appropriate hurdle rate
The Weaknesses of the NRV Method
A measurement similar to the yield to maturity measure of bonds which tells us what particular discount rate will result in a zero NPV project
Internal Rate of Return Technique
A firm should accept any project with an internal rate of return greater than or equal to a pre specified hurdle rate
IRR Rule
1 Take time value into account
2 provide results as a return measure rather than simple dollar measure
The Strengths of the IRR Method
1 if there is a unusual cash flow pattern (negative to positive) with lots of sign changes than there would be more than one internal rate of return
2 assumed re-invented at IRR which may not be realistic but there is a modified IRR which we will not be tested on
Weaknesses of the IRR Model
1 the profitability index
2 equivalent annual costs and project lengths
3 mutually exclusive projects and capital rationing
The 3 Capital Budgeting Extensions
There is no difference between benefits and costs expressed as a dollar amount in NPV method and taken as a ratio
The Profitability Index
Present Value of Net Cash Flow / Initial Investment
Profitability Index Formula
Implies choosing one means we don’t take on the other
Mutually Exclusive Projects
IRR is not as what as NPV because it assumes any project that exceeds the discount or hurdle rate will be taken on
Helpful
A firm puts a limit on the amount of its investments
Capital Rationing
1 investment decisions are a crucial function for almost any manager
2 time value of money are foundational for effective decisions
3 managers goal is to add value and this is largley done by positive net present value projects
Relevance for Managers of Investment Decisions
