Chp 9: Capital Budgeting Intro & Techniques Flashcards
what decision has the greatest impact on a business’s future than any other decision it makes?
investment decisions
what does capital refer to
long term securities and investments
define capital budgeting - 2 points
1) method for evaluating long term investment opportunities in which all cash flows are discounted to the present
2) process of deciding which long term investments or projects a firm will acquire
goal of financial manager and what do they need to do
increase shareholder wealth so they need to invest funds in projects that increase shareholder wealth
explain NPV analysis
continuous process when applied to big projects where sunk costs have to be ignored and the focus moves to completing the project
steps in capital budgeting process
1) identification of opportunities
2) evaluation of opportunities
3) selection
4) implementation
5) post audit
explain step 1 in capital budgeting process: identification of opportunities - 2 points
1) Firm’s need some method of identifying opportunities to the attention of managers
2) Employees on front lines must have both incentives and means to communicate ideas to those who implement them
explain step 2 in capital budgeting process: evaluation of opportunities
All costs and benefits need to be identified and analyzed
explain step 3 in capital budgeting process: selection
Projects must be ranked and selection because of limited funds or because of human/physical constraints the firm faces - they can’t accept everything
explain step 4 in capital budgeting process: implementation
Costs must be monitored and project risk must be evaluated
explain step 5 in capital budgeting process: post audit - 2 points
1) Once the project is completed, compare costs and revenues with original projections.
2) Employees must be responsible for errors in projections to give them an incentive to do be more accurate next time
Which of the following is NOT necessarily a step in the capital budgeting process? A.Post audit. B.Project rejection. C.Evaluation of opportunities. D.Identification of opportunities.
project rejection
The steps of capital budgeting include all of the following except: A.Pre Audit. B.Post Audit. C.Selection. D.Evaluation of Opportunities.
pre audit
An investment may change the whole face of a firm. True or false?
true
5 things a good capital budgeting decision tool should do
1) Use all the cash flow
2) Account for time value of money
3) Account for risk
4) Able to rank mutually exclusive projects
5) Have a link to increased firm value
5 capital budgeting decision tools
1) payback period (PB)
2) NPV
3) profitability index (PI)
4) IRR
5) modified IRR
3 points to payback period
1) Number of years required to recapture initial investment
2) = initial investment / annual cash flow
3) No decision criteria
3 points to NPV
1) The present value of all cash flows
2) = PV(cash inflows) - PV(cash outflows)
3) Accept if greater than or equal to 0
3 points to profitability index
1) Ratio of the PV of cash inflows to outflows
2) = PV (inflows) / PV (outflows)
3) Accept if greater than or equal to 1
2 points to IRR
1) Interest rate that sets the PV of cash inflows equal to PV of outflows
2) Accept if greater than or equal to cost of capital
2 points to modified IRR
1) Interest rate that sets PV of outflows equal to FV of inflows, computed at firm’s cost of capital
2) Accept if greater than or equal to cost of capital
True or False? Based on the Explain it! video and on the table, the decision criteria is used to evaluate the results of a capital budgeting analytic method so as to make the accept/reject decision.
true
single sentence good and bad thing for payback period
The easiest to compute but theoretically the worst evaluation method
payback period - what to do with unequal cash flow
make table to cash inflow and balance and when balance is last negative do balance/next cash inflow to get number of months in between. Multiply fraction by 12 to get months and round up. Note: balance for that year should be subtracted by cash inflow in that year.
2 advantages of payback period
1) Simple
2) Provides liquidity info (shorter the payback period, the greater the project’s liquidity)
4 disadvantages of payback period
1) No clearly defined accept/reject criteria
2) No risk adjustment (risky CF treated same as low risk CF)
3) Ignores cash flows beyond payback period
4) Ignores time value of money (large and early CF are valued as much as small, early CF)
when is payback period often used?
when some projects are too small to justify complexity of other methods
define discounted payback method
amount of time it takes for a project to recoup the investment and cost of capital
what does discounted payback method take into account?
This method takes into account time value of money, but not the other problems
All of the following are weaknesses of the payback period technique except:
A.Ignores time value of money.
B.Difficulty of calculation.
C.No clearly defined accept/reject criteria.
D.Ignores cash flows beyond payback period.
B.Difficulty of calculation.
Of the different techniques available for evaluating cash flows, which is technically the worst?
A.The internal rate of return (IRR)
B.The net present value (NPV)
C.The modified internal rate of return (MIRR)
D.The payback period
E.The profitability index (PI)
payback period
why is NPV widely used?
Most popular and theoretically sound evaluation tool
what does positive NPV mean
Positive NPV means current value of income exceeds current value of expense for project
what does negative NPV mean
Negative NPV means project costs more than it will bring in
what time does annuity find PV?
an annuity finds PV to period before first cash flow
3 advantages of NPV
1) Uses time value of money
2) Clear decision criteria
3) Discount rate adjusts for risk
2 disadvantages of NPV
1) Can be difficult for people without background in financial theory
2) Of little help when company must select among group of positive NPV projects
NPV relationship to firm value
NPV has a 1:1 relationship when increased firm value. If NPV of a project is $10, this means the value of the firm will increase by $10 by accepting the project.
what discount rate is used to evaluate capital budgeting projects and what it reflects
firm’s cost of capital. It reflects the risk of the firm and the firm’s average required return on its investments.
in excel what do you have to do for NPV?
manually subtract out the beginning cash outflow
define NPV profile
graphs NPV at various discount rates (as discount rate rises, NPV decreases to account for risk)
what does NPV profile show
Shows sensitivity of the project to the firm’s cost of capital
x and y axis for NPV profile
Various discount rates are on the x axis and NPV is on the y axis
NPV profile: graphing 2 projects at certain discount rate
At a certain discount rate, if we graph 2 projects, the one that is higher is the one to choose
why do we do a sensitivity analysis?
cost of capital is hard to estimate
how do we find NPV when discount rate is 0?
summing the cash flows
define profitability index
Provides a measure of the bang for the buck provided by investing in the project
what does profitability index tell you
Tells you how many dollars in PV terms you receive per dollar of investment
2 formulas for profitability index
1 + NPV/PV(cash outflow) or = PV(inflow)/PV(outflow)
PI when NPV =0
1
PI when NPV > 0
> 1
what 3 methods give same accept/reject decision and why?
NPV, IRR, PI
why must firm participate in capital rationing
Firm’s must limit its capital budget (ration its capital) due to real world constraints so firm’s need to rank projects
what does ranking projects by PI tell the firm?
Ranking project by PI lets the firm know which projects generate the highest return per dollar invested
when does ranking PI only work?
Ranking by PI works only if projects use all of the budgeted capital. The goal is to choose projects that combine to the highest NPV and sometimes the top ranked PI projects don’t do that
PI advantage
useful as aid in ranking
PI disadvantage
should not replace NPV as it can rank projects incorrectly when capital is rationed and does not provide measure of increase in firm value like NPV
Question: Which capital budgeting technique is most useful for ranking projects when faced with capital rationing? A.IRR. B.Payback period. C.NPV. D.PI.
PI
True or False? Using the PI to rank projects will always result in maximizing NPV.
false
Which of the following is an advantage of the net present value (NPV) technique for evaluating cash flows?
A.Easy comparison of separate NPV projects.
B.Ease of understanding.
C.Discount rate adjusts for risk.
D.100% accurate.
discount rate adjusts for risk
All of the following are true about profitability index (PI) except:
A.Calculated by dividing the present value of inflow by the present value of the outflows.
B.Will always give the same accept/reject decision as NPV.
C.Works well as a supplement for the NPV method.
D.Is best used by itself.
is best used by itself
define IRR
Discount rate that sets PV of cash inflows equal to present value of cash outflows (sets NPV = 0)
what is the hurdle rate?
cost of capital
2 advantages of IRR
1) Easy to interpret and explain
2) Investors like to speak in terms of annual percentage returns when evaluating investment options
5 disadvantages of IRR
1) Assumes cash flows are reinvested at IRR when they are received
2) Cannot be used to rank mutually exclusive projects because it does not evaluate projects at particular discount rates
3) Ignores differences in scale since cash flows are converted to percentages
4) Will generate multiple IRRs(or no IRR solution) if cash flows change direction.
on NPV profile, where can we find IRR?
On an NPV profile, the IRR (or multiple) are where the graph crosses the x axis
what happens if there are multiple IRRs
we cannot use IRR, it is invalid
Question: Which of the following is NOT a disadvantage of the IRR method for capital budgeting?
A.The reinvestment assumption may lead to wrong ranking decisions.
B.Results are hard to interpret.
C.May not be a single solution.
D.IRR does not provide information for project scale.
B.Results are hard to interpret.
Question: The problem with the reinvestment rate assumption is:
A.IRR assumes all cash flows are not reinvested.
B.IRR assumes all cash flows are reinvested at the IRR.
C.IRR assumes all cash flows are reinvested at the highest return available.
D.IRR assumes all cash flows are reinvested at the cost of capital.
B.IRR assumes all cash flows are reinvested at the IRR.
what are future value of cash flows called?
terminal value
what does modified IRR solve?
Solves the IRR problem of reinvestment rate because cash flows are compounded at cost of capital. Also solves problem of changing CF signs resulting in multiple IRR’s
explain MIRR in terms of interest rate
Is the interest rate that grows the present value to equal the future value
MIRR: where are cash inflows compounded to?
Cash inflows are compounded to the point at which the last cash inflow is received
The internal rate of return (IRR) can be defined as:
A.The results of the NPV converted to a ratio.
B. The discount rate that sets NPV to 0.
C.The number of years required to recover the initial investment.
D.The sum of the future cash flows discounted back to the current period.
B.The discount rate that sets NPV to 0.
The difference between the internal rate of return (IRR) and the modified internal rate of return (MIRR) is:
A.MIRR is a simpler version of IRR that does not require a calculator to solve.
B.IRR is more accurate.
C.MIRR solves the reinvestment rate assumption problem.
D.IRR deals with outflows where the MIRR deals with inflows.
C.MIRR solves the reinvestment rate assumption problem.
What major problem with IRR does the MIRR solve?
A.The ranking problem.
B.Evaluation of the timing of the cash flows.
C.The scaling issue.
D.The reinvestment rate assumption issue.
D.The reinvestment rate assumption issue.
what do we need to pay attention to payback period?
if payback period exceeds years of revenue, there is no payback (if PV cost exceeds PV revenues)
