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FN1 part 2 > chpater 13 ppt > Flashcards

chpater 13 ppt Flashcards

1
Q

what is Capital Expenditures

A

a firm’s investments in long-lived or fixed assets

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2
Q

what are the types of capital expenditures

A
  1. tangible - such as property, plant and equipment 2. Intangible - such as research and development knowledge, patents, copyrights, trademarks, brand names and franchise agreements
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3
Q

Capital expenditures decisions determine what

A

the future direction of a company and are among the most important that a firm can make

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4
Q

why is capital expenditure among the most important decision a firm can make

A
  1. involves a very significant outlay of money and managerial time 2. takes many years to demonstrate their return 3. are irrevocable 4. significantly alter the risk of the entire firm because of their size and long-term nature
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5
Q

what is capital budgeting

A

the process through which a firm makes capital expenditure decisions

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6
Q

what does capital budgeting involve

A

identifying and evaluating investment alternatives, implementing the chosen proposals, and monitoring implemented decisions

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7
Q

what are Michael Porter’s Five Forces

A
  1. entry barriers 2. threat of substitute products 3. Bargaining power of buyers 4. bargaining power of suppliers 5. rivalry among existing competitors
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8
Q

what is Michael Porter’s five forces (describe what it is)

A

identifies 5 critical factors that determine the attractiveness of an industry

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9
Q

Companies do exert control over how they strive to create a competivitve advantage within their industry. they can strive for what

A
  1. Cost leadership 2. Product differentiation
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10
Q

what is an example cost leadership

A

ie. be the lowest cost producer

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11
Q

what is an example of product differentiation

A

have products considered unique

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12
Q

is it easy or hard to sustain a competitive advantage

A

difficult and requires on-going planning and investment

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13
Q

how should capital expenditure decision be made

A

with a strategic focus and be subject to rigorous financial analysis

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14
Q

what is bottom up analysis

A

an investment strategy in which capital expenditure decisions are considered in isolation without regard for whether the firm should continue in its particular business or for general industry and economic trends

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15
Q

what is top-down analysis

A

is an investment strategy that focuses or strategic decisions, such as which industries or products the firm should be involved in, looking at the overall economic picture

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16
Q

Capital expenditure decisions, like security valuation, must take into account

A

timing, magnitude, and riskiness of net incremental after-tax cash flow benefits that an initial investment is forecast to produce

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17
Q

Unlike security valuation, however, analysts can change what

A

the underlying cash flows by changing the structure of the project to impact its feasibility and profitability

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18
Q

All discounted cash flow (DCF) methods require what

A

an estimate of the initial investment, the net incremental after-tax cash flows, and the required rate of return on the project for the discount rate

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19
Q

We will consider four DCF methods for evaluating investment alternatives what are they

A

net present value (NPV), internal rate of return (IRR), payback period and discounted payback period, and profitability index (PI).

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20
Q

The firm’s cost of capital determines what

A

the minimum rate of return that would be acceptable for a capital project

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21
Q

The weighted average cost of capital (WACC) is what

A

the discount rate (k) used in NPV analysis, assuming the risk of the project being evaluated is similar to the risk of the overall firm, and the hurdle rate for IRR analysis

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22
Q

If the risk of the project differs from what

A

the risk of the overall firm, however, a risk-adjusted discount rate (RADR) should be used.

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23
Q

RADRs can be estimated using two techniques what are they

A
  1. CAPM after determining the projects beta 2. Pure-play approach
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24
Q

what does the CAPM approach used for RADRs involve

A

This approach involves forecast ROA that must be regressed against the ROA of the market index, and estimation errors can be significant.

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25
Q

what does the Pure-Play approach used for RADRs invole

A

where you find the cost of capital of another firm operating in the industry associated with the project. The key to this approach is that the firm must not be diversified across industries but truly represent an investment solely in that industry.

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26
Q

what is the net present value analysis formula

A

n

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27
Q

Essentially, the net present value (NPV) is

A

the present value of all benefits (net cash inflows) minus the present value of costs (net cash outflows)

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28
Q

If PV(benefits) > PV(costs), then

A

•NPV > 0 and the project is acceptable because it will add value

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29
Q

If PV(benefits) < PV(costs), then

A

•NPV < 0 and the project should not be accepted because it will destroy value

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30
Q

What type of measure is NPV

A

absolute measure

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31
Q

how is NPV expressed

A

expressedi n present dollars , of the net incremental benefit the project is forecast to bring shareholders

32
Q

in a perfectly efficient market, the total value of the firm should

A

rise by the value of the NPV if the project is undertaken

33
Q

NPV Analysis

•Example: Suppose a company has an investment that requires an after-tax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax cash flows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. Using a 15% discount rate, determine the project’s NPV.

A

1388.67

CF 2nd CRL WORK

-12,000 enter down arrow down arrow

5,000 enter down arrow down arrow

5,000 enter down arrow down arrow

8,000 enter down

NPV 15 enter down

CPT = 1388.67

34
Q

A NPV Profile is a set of

A

NPVs for a project created by varying the discount rate used to find the PV of the cash flows

35
Q

An NPV profile is also the slope of what

A

the line create when the results are graphed; the longer the life of a project, the steeper the slpe of the NPV profile

36
Q

what is the Internal Rate of return (IRR)

A

is the discount rate that causes NPV of the project to equal zero

37
Q

what is the formula for NPV

A
38
Q

if the IRR is greater than WACC, then the project is

A

acceptable becasue it is forecast to yield a rate of return on invested ccapital that is greater than the cost of the fund invested in the project

39
Q

if the IRR is less than WACC the project should

A

not be accepted because the investment will not earn its cost of capital

40
Q

The Internal Rate of Return (IRR)

  • Example: Suppose a company has an investment that requires an after-tax incremental cash outlay of $12,000 today. It estimates that the expected future after-tax cash flows associated with this investment are $5,000 in years 1 and 2, and $8,000 in year 3. The cost of capital is 15%. Determine the project’s IRR.
  • There is no closed-form formula solution for IRR. It can be solved iteratively, but technology expedites the process significantly.
A

CF 2nd Clr Work

-12,000 enter down arrow

5,000 enter down arrow down arrow

5,000 enter down arrow down arrow

8,000 enter down arrow

IRR CPT

= 21.31%

41
Q

What are the similarities of NPV and IRR

A

both metods use the same basic decision inputs

42
Q

What are the NPV and IRR differences

A

the assumed discount rate:

IRR - assumes intermediate cash flows are reinvested at the IRR

NPV - assumes that they are reinvested at the WACC+

43
Q

the difference between NPV and IRR can produce conflicting decision results under specific conditions what are they

A
  1. evaluating two or more mutually exclusive investement proposals
  2. NPV profiles of the project have different slopes and cross at a Positive NPV
  3. the cost of capital (Relevant disocunt rate) is lower than the crossover discount rate
44
Q

Comparing NPV and IRR

Issue: Future cash flows change sign

A

NPV - works the same way for both accept/reject and ranking decisions

IRR - multiple IRRs may reuslt - in this case, the IRR cannot be used for either accept/reject or ranking decisions

45
Q

Comparing NPV and IRR

Issue: Ranking projects

A

NPV - the higher NPV imples greater contribution to firm wealth - it is an absolute measure of weath

IRR- the higher IRR project may have a lower NPV and vice versa, depending on the appropriate discount rate and the size of the project. for example would analysts prefer an IRR of 100% on $1,000 or 20% on $1 million

46
Q

Comparing NPV and IRR

Issue: reinvestment rate assumed for future cash flows received

A

NPV - assumes all future cash flows are reinvested at teh dsicount rate, this is appropriate because it treats the reinvested of all future cash flows consistently, and k is the investor’s opporutnity cost

IRR - assumes cash flows from each project are reinvested at that project’s IRR, this is inappropriate, particularly when the IRR ishigh

47
Q

in this figure, the IRR of B is 15% while the IRR of A is only 12%, so IRR would suggest what

A

that B is better than A

but notice, that the NPV of A is greater when the discount rate is lower than the 9% crossover rate

48
Q

Comparing NPV and IRR

A
  • Both NPV and IRR use the same inputs
  • NPV measures in absolute terms the estimated increase in the value of the firm today that the project is forecast to produce, and assumes that cash flows are reinvested at WACC
  • IRR estimates the project’s rate of return and assumes that cash flows produced by the project are reinvested by the firm at the project’s IRR
  • The reason for the different accept/reject decisions is the different reinvestment rate assumptions used by the two techniques
49
Q

A Comparison of NPV and IRR

•Which method should be relied upon?

A

–It depends which reinvestment assumption is more realistic
–Most often, the NPV assumption of reinvestment at WACC is the most realistic because no rational manager would reinvest cash flows at rates lower than the firm’s cost of capital
–If projects with high IRRs are rare, then reinvestment may not be possible

50
Q

A Comparison of NPV and IRR

Despite the inherent superiority of the NPV approach, CFOs continue to what

A

use other appraoches and do not necessarily favour NPV over IRR

perhaps the reason for this is that it is difficult for people to undersding what a positve NPV really means

51
Q

what is the payback period

A

is a simple apprach to capital budgeting that is designed to tell you how many years it will take to recover the initial investment

52
Q

who is the payback period often used by

A

financial managers as one of a set of inestment screens, becasue it gives teh manager an intuitve sense of the prject’s risk

53
Q

what is the discounted payback period

A

overcomes the lack of consideration of time value of money that is poblematic with the simple payback period

graphicing the cumulative PV of cash flows can help identify the pattern of cash flows beyond the payback point

if carried to the end of ht eproject’s useful life, it will tell us the project’s NPV if the WACC is used as the discount rate

54
Q

Payback Period and Discounted Payback Period

•Example: Determine the payback and discounted payback for a project that costs $100,000 to implement and gives $60,000 after-tax cash flows for six years

A

•Solution: the payback period is 1.7 years and the discounted payback period is 1.9 years

Year

CF

Discounted

CF

Cumulative

CF

Cumulative Discounted CF

0

  • $100,000
  • $100,000
  • $100,000
  • $100,000

1

$60,000

$54,545

  • $40,000
  • $45,455

2

$60,000

$49,587

$20,000

$4,132

3

$60,000

$45,079

4

$60,000

$40,981

5

$60,000

$37,255

6

$60,000

$33,868

55
Q

what is the Profitability Index (PI)

A

uses exactly the same decision inputs as the NPV

  • the PI simply expresses the relative profitability of the project’s incremental after-tax cash flow benefits as a ratio to the project’s initial cost
56
Q

Profitability Index

If PI is greater than 1,

A

accept the project because the PV(Benefits) is gerater than the PV Costs

57
Q

if Profitabiilty Index is less than 1,

A

do not accept the project becasue the PV(B eneifts) are less than PV (costs)

58
Q

What are independent projects

A

they have no relationship with one anohter

therefore, the decision to implement one project has no mpact on the decision to implment anoter project

–Example: Building a store in Ottawa is independent of building a store in Edmonton

59
Q

what are contingent projects

A

are projects where the acceptance of one requires the acceptance of anoter, either as a prerequisite or simultaneously

–Example: Building a retail outlet in Edmonton requires warehouse space in Edmonton

60
Q

what are mutually exclusive projects

A

are substitutes where the decision to accept one project automatically means all other substitute proposals are rejected

–Example: A commercial development on a parcel of land in Edmonton means an apartment building will not be built there

61
Q

what are the two appraoches to adjust for lives among mutually exclusive projects

A
  1. chain replication
  2. equivalent annual NPV (EANPV)
62
Q

what is chain replication

A

finds a time horizon into wich all the project lives under consideration will divied equally (ie their lowest common multiple) and then assumes each project repeats until ti reaches this horizon.

this implicitly assumes the projects ar erepeatable on the same terms into the future

63
Q

what re equivalent annual NPV (EANPV) appraoch

A

compares projects by finding the NPV of th eindividual projects and then determining the amoutn of an annuity that is economically equivalent to the NPV generated by each project over its respective time horizon

64
Q

what is captial rationing

A

the corporate practice of limiting the amoutn of funds dedicated to capital investments in any one year

65
Q

why is capital rationing academically illogical

A
  • why would a manager not invest in a project that will offer a greater return than the cost of capital used to finance it?
  • In the long-run, it could threaten a firm’s continuing existence through the erosion of its competitive position
66
Q

why would shareholders want capital rationing

A

•But the firm may have owners who do not want to raise additional external equity because it will mean ownership dilution of their share

67
Q

what is another reason other than shareholders for captial rationing

A

•The firm may also have so many worthy investment projects that taking advantage of all of them exceeds the firm’s short-term managerial capacity

68
Q

under capital rationing the cost of capital is

A

no longer appropriate opportunity cost

69
Q

with regards to captial rationing, IRR may have

A

more validity becasue the firm may be able ot reinvest its cash flows at rates that are igher than the cost of capital

70
Q

the proffitability indiex may also be a useful staring point in Captial rationing because

A

it ranks projects on PV per unit of investment

71
Q

in the absence of capital rationing, NPV, IRR and PI will

A

select value maximizing projects

72
Q

what is investment opportunity schedule (IOS)

A

is a prioritizied list of capital proejcts, ranked form highest to lowest with the cumulative invetestment required also listed

  • Investments can be ranked according to any metric, but only NPV ensures maximization of shareholder wealth
  • Example: Suppose a firm has a 10% cost of capital and six projects from which it can choose to allocate $6 million in capital investment

Project Initial cost annual ATCF useful life NPV IRR PI

73
Q

•Example: Suppose a firm has a 10% cost of capital and six projects from which it can choose to allocate $6 million in capital investment

A

•In the absence of capital rationing, all three methods choose value maximizing project and reject value destroying projects

74
Q

•Capital investment decisions that involve foreign investment should taking into account additional factors:

A

–Political risk
–Potential legal and regulatory issues
–Adjustments for foreign exchange risk
–Adjustments for foreign taxation
–Sources of financing if local capital markets are poorly developed or unsuitable

75
Q

what is Export Development Canada (EDC) and what does it do

A
  • is a federal crown corporation that helps Canadian firms export and make foreign direct investment (FDI)
  • EDC provides insurance products to mitigate some risks of FDI
76
Q

FDI outside of Canada is what and why

A

•FDI outside of Canada is a growing phenomenon as Canadian companies are increasing seeking international investment opportunities
EDC encourages Canadian companies to look beyond the U.S. for FDI

77
Q
A

FN1 part 2 (7 decks)

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