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Comm 305: Managerial Accounting > COMM 308chapter 13: Capital Budgeting, Risk Considerations, and Other Special Issues > Flashcards

COMM 308chapter 13: Capital Budgeting, Risk Considerations, and Other Special Issues Flashcards

1
Q

Capital expenditures

A

a firm’s investments in long-lived asset (can be tangible and intangible)

usually involve large amounts of money

the decisions are frequently irrevocable

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2
Q

Capital budgeting

A

the process by which a firm makes capital expenditure decisions

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3
Q

the process steps by which a firm makes capital expenditure decisions (capital budgeting)

A

(1) identifying investment alternatives
(2) evaluating these alternatives
(3) implementing the chosen investment decisions
(4) monitoring and evaluating the implemented decisions

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4
Q

how can securities reflect capital expenditure decisions?

A

if they messed up, people will know and will not think that investing in these companies is a good decision

security price decreases

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5
Q

Michael Porter’s five critical factors that determine the attractiveness of an industry

the five forces

A

entry barriers

the threat of substitutes

the bargaining power of buyers

the bargaining power of suppliers

rivalry among existing competitors

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6
Q

according to Michael Porter, what do firms have little control over after inception?

A

the attractiveness of the industry they are in

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7
Q

according to Michael Porter, what do firms have total control over?

A

over the manner in which they strive to create a competitive advantage within their industry

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8
Q

according to Michael Porter, what can firms do to obtain competitive advantage?

A
  1. Cost leadership: strive to be a low-cost producer

or

  1. Differentiation: offer “differentiated” products
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9
Q

Cost leadership: strive to be a low-cost producer

A

viable for firms that are able to take advantage of economies of scale, proprietary technology, or privileged or superior access to raw materials

investment outlays should be made in accordance with a firm’s potential advantage

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10
Q

Differentiation: offer “differentiated” products

A

Firms can provide products that are differentiated from others in several ways

–> The most obvious is to have a product that is itself unique by virtue of its physical or technological characteristics

–> However, firms can also differentiate their products by providing customers with unique delivery alternatives or by establishing a marketing approach that distinguishes their products from those of their potential competitors

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11
Q

Porter suggests that it is difficult to sustain a competitive advantage once one has been created, what must companies keep doing then?

A

companies must continually plan (and invest) strategically

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12
Q

Bottom-up analysis

A

based on the idea that a firm is simply a set of capex decisions

an investment strategy in which capex decisions are made in isolation, without considering general industry and economic trends or whether the firm should continue in this particular business

involves probabilities and estimates

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13
Q

Equipment replacement is a typical bottom-up analysis or top-down analysis?

why?

A

a typical bottom-up analysis

an engineer estimates the savings that will be realized by replacing one piece of equipment with another

A financial analyst then translates these savings into financial parameters to determine whether the replacement savings are worth the cost of the equipment

at no point does the engineer or the financial analyst consider whether the firm should continue in this business

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14
Q

top-down analysis

A

focuses on strategic decisions about which industries or products the firm should be involved in

looking at the overall economic picture

involves uncertainty which can’t be calculated using probabilities

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15
Q

In looking at bottom-up versus top-down analysis, what stays the same?

A

the capital budgeting framework

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16
Q

In looking at bottom-up versus top-down analysis, what is different?

A

the quality of the estimates

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17
Q

discounted cash flow (DCF) methodologies

A

techniques for making capex decisions that are consistent with the overriding objective of maximizing shareholder wealth

involves estimating future cash flows and comparing their discounted values with investment outlays required today

they are technically identical to the approaches used to evaluate bonds and preferred and common shares

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18
Q

The payback period method

A

defined as the number of years required to fully recover the initial cash outlay associated with a capital expenditure

we use a cutoff date

provides a useful intuitive measure of how long it takes to recover an investment and is sometimes used as an informal measure of project risk

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19
Q

shorter or longer payback periods are better?

A

shorter payback periods

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20
Q

how can the payback period method measure risk?

A

the quicker a firm recovers its investment outlay, the less risky the project is

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21
Q

drawbacks of the payback period method

A
  1. it disregards the time and risk value of money, because it treats a dollar of cash flow received in year 3 the same as those received in year 1, and so on
  2. the payback period does not account for the cash flows received after the cutoff date, which could be substantial for some long-lived projects
  3. the choice of the cutoff date is somewhat arbitrary and may vary from one firm to the next
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22
Q

The discounted payback period method

A

alleviates the first shortcoming of the payback period by accounting for the time value of money

the number of years required to fully recover the initial cash outlay in terms of discounted cash flows

Shorter periods are better, and projects with discounted payback periods before the cutoff date will be accepted

23
Q

drawbacks of the discounted payback period method

A

ignores cash flows beyond the cutoff date

the cutoff date is somewhat arbitrary

24
Q

The net present value (NPV) of a project

A

defined as the sum of the present value (PV) of all future after-tax incremental cash flows generated by an initial cash outlay, minus the present value of the investment outlays

the present value of the expected cash flows net of the costs needed to generate them

it is like the Real Estate class, if you can use excel, do it

25
Q

Cash flows that have already been incurred in the NPV method

A

“sunk” costs and are ignored

they do not change as a result of the firm’s investment decision

26
Q

incremental in capital budgeting

A

the change in revenues or costs resulting from the investment decision

27
Q

risk-adjusted discount rate (RADR)

A

a discount rate set based on the overall riskiness of the project

28
Q

what does a positive NPV mean for a firm?

A

add value to the firm

should be accepted because, by definition, a positive NPV implies that the PV of the expected future cash flows will exceed the cash outlay today

29
Q

The internal rate of return (IRR)

A

the same as the yield to maturity (YTM) for a bond

the discount rate that makes the NPV equal to zero for a given set of cash flows

the discount rate that sets the PV of future CFs equal to the initial cash outlay

often called the “economic rate of return” of a given project

30
Q

The general rule for IRR evaluation criteria

A

a firm should accept a project whenever the IRR is greater than the appropriate risk-adjusted discount rate (k) (usually the firm’s cost of capital)

31
Q

as the discount rate increases, what happens to the NPV?

A

it decreases

32
Q

when the NPV curve crosses the x axis (the horizontal axis), what does this mean for the IRR?

A

this means that that point of discount rate is our IRR

33
Q

if the discount rate is more than the IRR, what happens to our NPV?

A

our NPV becomes negative

34
Q

if the discount rate is less than the IRR, what happens to our NPV?

A

our NPV becomes positive

35
Q

mutually exclusive projects

A

a situation in which the acceptance of one project precludes the acceptance of one or more alternative projects

36
Q

the crossover rate

A

a special discount rate at which the net present value profiles of two projects cross (are equal)
at this discount rate, the NPV between two mutually exclusive project is the same

37
Q

the slope of the NPV curve

A

reflects the change in the NPV as the discount rate changes

38
Q

differences between the NPV and IRR decisions

A

the NPV decision depends on the discount rate, whereas the IRR decision does not

The NPV assumes that all cash flows are reinvested at one consistent discount rate

–> The IRR assumes instead that all cash flows are reinvested at the IRR

39
Q

which assumption between the IRR and NPV is more realistic?

A

the NPV assumption

40
Q

which method is more widely used to make capital budget decisions between the NPV and IRR?

A

NPV (74.65)

IRR is close at 68.4%

41
Q

NPV versus IRR

Issue: Future cash flows change sign

A

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

IRR: Multiple IRRs may result—in this case, the IRR cannot be used for either accept/reject or ranking decisions

42
Q

NPV versus IRR

Issue: Ranking projects

A

NPV: Higher NPV implies greater contribution to firm wealth—it is an absolute measure of wealth

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 percent on $1,000 or 20 percent on $1 million?

43
Q

NPV versus IRR

Issue: Reinvestment rate assumed for future cash flows received

A

NPV: Assumes all future cash flows are reinvested at the discount rate. This is appropriate because it treats the reinvestment of all future cash flows consistently, and k is the investor’s opportunity cost.

IRR: Assumes cash flows from each project are reinvested at that project’s IRR. This is inappropriate, particularly when the IRR is high.

44
Q

The profitability index (PI) index

A

another DCF approach used to evaluate capital expenditure decisions

a relative measure of project attractiveness

defined as the ratio of a project’s discounted net incremental after-tax cash inflows over the discounted cash outflows, which are usually the initial after-tax cash outlays

projects with ratios greater than one should be accepted because, by definition, they have positive NPVs

It is also obvious that larger ratios are favoured because their NPVs are higher

45
Q

benefits of the PI over the IRR

A

the PI produces the same accept/reject decisions as do the NPV

the PI does not suffer from two of the weaknesses of the IRR, because it uses one consistent and reasonable discount rate and because it works even when future cash flows change signs

Like the IRR, the PI is attractive because it can be expressed as a percentage

46
Q

One weakness that the PI shares with IRR

A

it is a relative measure and not an absolute measure of wealth, like NPV

47
Q

when is the PI often used?

A

when firms are constrained by their capital budget

48
Q

Independent projects

A

have no relationship with one another

49
Q

interdependent projects

A

projects that are related such that accepting or rejecting one has an impact on the value of other projects under consideration

50
Q

Projects with unequal lifespans can be compared by using which two approaches?

A

The chain replication approach

The equivalent annual NPV (EANPV) approach

51
Q

contingent projects

A

projects for which the acceptance of one requires the acceptance of another either beforehand or simultaneously

the rule is to estimate the total NPV of all contingent projects and accept them if this total NPV is positive

52
Q

The chain replication approach

A

involves finding a time horizon into which all the project lives under consideration divide equally and then assuming each project is repeated until they all reach this horizon

For example, if a firm is comparing a three-year project with a four-year project, it would assume the three-year project could be replicated four times and that the four-year project could be replicated three times (for a total of 12 years each)

It then finds the PV of all the replicated projects for each individual project and chooses the one that generates the highest NPV over the entire period, assuming the NPV is positive

53
Q

The equivalent annual NPV (EANPV) approach

A

finds the NPVs of individual projects and then determines the amount of an annual annuity that is economically equivalent to the NPV generated by each project over its respective time horizon

Comm 305: Managerial Accounting (32 decks)

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