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Fin 301 > Final exam - Chapter 9 > Flashcards

Final exam - Chapter 9 Flashcards

1
Q

What are the 4 Decision Models for Evaluating Alternatives

A

Net Present Value (NPV)
Profitability Index (PI)
Internal Rate of Return (IRR)
Payback Period (PB)

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2
Q

Capital Budgeting: Decision Criteria and real option consideration
What is the main goal

A

To figure out to accept or reject the project

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3
Q

Capital rationing

A

is the act of placing restrictions on the amount of new investments or projects undertaken by a company. This is accomplished by imposing a higher cost of capital for investment consideration or by setting a ceiling on specific portions of a budget.

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4
Q

Formula for Net Present Value

A

NPV = PV (All NCF’s) - NINV

It should be positive

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5
Q

Net Present Value

A

The present value of the stream of future
cash flows from a project minus the
project’s net investment

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6
Q

NPV
Independent Projects
Which one to accept?

A

Accept if its net present value is greater than or
equal to zero and reject if its net present value
is less than zero

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7
Q

NPV
Mutually Exclusive Projects
Which one to accept?

A

Accept the project with the largest net present value

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8
Q

When product and factor markets are not
perfectly competitive, it is possible for a
firm to

A

earn above-normal profits that

result in positive net present value projects

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9
Q

(3) NPV advantages

A

Advantages

Theoretically the best criteria among 4 decision
models
Realistic assumption that cash flows are
reinvested at the cost of capital
Considers the time value of money

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10
Q

(2) NPV disadvantages

A

Disadvantages

NPV result not easily understood
Does not consider the value of real options

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11
Q

Profitability Index

A

The ratio of the present value of expected
net cash flows over the life of a project to
the net investment

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12
Q

The ratio of the present value of expected
net cash flows over the life of a project to
the net investment

A

Profitability Index

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13
Q

Profitability Index

Formula

A

Profitability Index=
Present Value (All NCF’s)
/
Net investment

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14
Q

Should the Net Present Value be positive or negative

A

positive

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15
Q

Which project would you use choose
PI= 0.97
PI= 1.15

A

PI= 1.15

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16
Q

PI

 Independent Projects

A

Accept if the profitability index is greater than or

equal 1

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17
Q

PI

 Mutually Exclusive Projects

A

Accept the project with the largest profitability
index
Conflicts may occur between NPV and PI for
mutually exclusive projects

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18
Q

Internal Rate of Return

A

Discount rate that makes NPV = 0

19
Q

Internal Rate of Return Formula

A 
NPV = 
Sum 
NCF
/
(1+IRR)^t
  • NINV

= 0

20
Q

IRR

 Independent Projects

A

Accept if the IRR is greater than the cost of

capital

21
Q

IRR

 Mutually Exclusive Projects

A

Accept the project with the higher IRR
Conflicts may occur between NPV and IRR for
mutually exclusive projects

22
Q

IRR advantages

A

Advantages

Considers the time value of money
Interpretation easier than NPV

23
Q

IRR

Disadvantages

A

Disadvantages

Non-normal cash flow pattern (can result in
multiple IRRs)
Assumption that cash flows are reinvested at
IRR sometimes unrealistic
Does not consider the value of real options

24
Q

How do NPV and IRR differ in how each

handles the reinvestment of cash flows?

A

NPV - cost of capital

IRR - IRR

25
Q

NPV: Assumes cash flows are reinvested at the

A

cost of capital

26
Q

IRR: Assumes cash flows are reinvested at the

27
Q

Which one is more realistic?

Between IRR and NPV

28
Q

Payback Period =

A

Net Investment
/
Annual Net Cash
Inflows (loosely speaking)

29
Q

Discounted Payback Period

A

uses the net cash
inflows, discounted at the firm’s cost of capital,
in determining the number of years required to
recover the net investment in a project

30
Q

uses the net cash
inflows, discounted at the firm’s cost of capital,
in determining the number of years required to
recover the net investment in a project

A

Discounted Payback Period

31
Q

Decision Rule for Payback Period

A

Accept if the payback period is less than or

equal to a specified maximum period

32
Q

PB advantages

 Advantages

A

PB advantages

Simple
Provides a measure of liquidity
A measure of risk
For this reason, both of NPV and PB criteria are often
used together in the industry where fast technological
changes are common. 21 

33
Q

PB Disadvantages

A

Disadvantages

Ignores the time value of money
No objective decision criterion
Ignores cash flows after the payback period
May not maximize shareholder wealth

34
Q

Read the summary slide on page 11 for every model

35
Q

What should a firm do if it does
not have enough money to
invest in all of its positive NPV
projects?

A

Pick the highest PI one

36
Q

Capital Rationing and the Capital

Budgeting Decision

A

Many firms do not have unlimited funds
available for investment, so there is a
constraint on the amount of funds
allocated to capital investments

37
Q

Capital Rationing and the Capital
Budgeting Decision
 When there is a capital budgeting constraint, an approach employing the profitability index can be used

A

Step 1
 Calculate the profitability index for each of a series of investment projects

Step 2
 Rank the projects according to their profitability indexes from highest to lowest

Step 3
 Beginning with the project with the highest profitability index, proceed through the list, and accept projects having profitability indexes greater than or equal to 1 until the entire capital budget has been utilized

38
Q

(3) Reviewing and Post-Auditing an

Accepted Project

A 
Compare actual cash flows to projected
cash flows
Find systematic biases or errors in
uncertain projected cash flows
Decide whether to abandon or continue
projects that have done poorly
39
Q

Does the Cost of Cpaital already include the effects of expected inflation

40
Q

The cost of capital already includes the

effects of _____ ______

A

expected inflation

41
Q

All cash flow estimates should also be

adjusted to reflect _____ ______ _____

A

anticipated inflationary

increases

42
Q

Real Options in Capital Budgeting
Classification of Real Options in Capital
Budgeting

A 
Investment Timing Options
Abandonment Option
Shutdown Options
Growth Options
Designed-In Options
43
Q

Designed-In Options

A

Input Flexibility
Output Flexibility
Expansion Options

Fin 301 (9 decks)

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