Final Exam Study Prep

Question 1

What is capital budgeting?

Answer 1

• Analysis of potential projects
• Long-term decisions; involve large expenditures.
• Very important to firm’s future.

Question 2

Steps in Capital Budgeting

Answer 2

1. Estimate cash flows (inflows & outflows)
2. Assess risk of cash flows.
3. Determine r = WACC for project.
4. Evaluate cash flows.

Question 3

Capital Budgeting Project Categories

Answer 3

• Replacement to continue profitable operations
• Replacement to reduce costs
• Expansion of existing products or markets
• Expansion into new products/markets
• Contraction decisions
• Safety and/or environmental projects
• Mergers
• Other

Question 4

Projects are independent if

Answer 4

The cash flows of one are unaffected by the acceptance of the other.

Question 5

Projects are mutually exclusive if

Answer 5

The cash flows of one can be adversely impacted by the acceptance of the other.

Question 6

How size can affect an NPV profile cross

Answer 6

Smaller project frees up funds at t = 0 for investment. The higher the opportunity cost, the more valuable these funds, so high r favors small projects.

Question 7

How can timing differences affect an NPV profile cost

Answer 7

Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF is especially good.

Question 8

Modified Internal Rate of Return (MIRR)

Answer 8

The discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. Thus, MIRR assumes cash inflows are reinvested at WACC.

Question 9

Profitability Index

Answer 9

The present value of future cash flows divided by the initial cost.

Question 10

What is the payback period?

Answer 10

The number of years required to recover a project’s cost, or how long does it take to get the business’s money back.

Question 11

Strengths and Weaknesses of Payback

Answer 11

Strengths:
- Provides an indication of a project’s risk and liquidity.
- Easy to calculate and understand.
Weaknesses:
- Ignores the TVM
- Ignores CFs occurring after the payback period.
- No specification of acceptable payback.

Question 12

What’s the incremental cash flow for a project

Answer 12

‘Corporate cash flow with the project’ minus ‘Corporate cash flow without the project’

Question 13

Should you subtract interest expense or dividends when calculating CF?

Answer 13

No. We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors.

Question 14

What is an asset’s depreciable basis?

Answer 14

Cost + Shipping + Installation

Question 15

Why is it important to include inflation when estimating cash flows?

Answer 15

If you discount real CF with the higher nominal r, then your NPV estimate is too low. Nominal CF should be discounted with nominal r, and real CF should be discounted with real r.

Question 16

What if you terminate a project before the asset is fully depreciated?

Answer 16

Basis = Original basis - Accum. Depreciation.

Question 17

What does ‘risk’ mean in capital budgeting?

Answer 17

Measured by stdev_NPV, stdev_IRR, beta.

Question 18

What three types of risk are relevant in capital budgeting?

Answer 18

Stand-alone risk, corporate risk, market (or beta) risk.

Question 19

Stand-Alone Risk

Answer 19

The project’s risk if it were the firm’s only asset and there were no shareholders. Ignores both firm and shareholder diversification.

Question 20

Corporate Risk

Answer 20

Reflects the project’s effect on corporate earnings stability. Considers firm’s other assets (diversification within firm). Depends on project’s stdev, its correlation p, with returns on firm’s other assets. Measured by the project’s corporate beta.

Question 21

Market Risk

Answer 21

Reflects the project’s effect on a well-diversified stock portfolio. Takes account of stockholders’ other assets. Depends on project’s stdev and correlation with the stock market. Measured by the project’s market beta.

Question 22

How is each type of risk used?

Answer 22

Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employees are more affected by corporate risk. Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk. If the project is highly correlated with the economy, stand-alone risk also reflects market risk.

Question 23

Results of Sensitivity Analysis

Answer 23

Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV.

Question 24

Weaknesses of Sensitivity Analysis

Answer 24

Does not reflect diversification. Says nothing about the likelihood of change in a variable. Ignores relationships among variables.

Question 25

What is a simulation analysis?

Answer 25

A computerized version of scenario analysis that uses continuous probability distributions.

Question 26

What is a real option?

Answer 26

Real options exist when managers can influence the size and risk of a project’s cash flows by taking different actions during the project’s life in response to changing market conditions.

Question 27

Some types of real options

Answer 27

Investment timing options, growth options, abandonment options, flexibility options.

Question 28

What is the single most important characteristic of an option?

Answer 28

It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset.

Question 29

Five Procedures for Valuing Real Options

Answer 29

1. DCF analysis of expected cash flows, ignoring the option.
2. Qualitative assessment of the real option’s value.
3. Decision tree analysis.
4. Standard model for a corresponding financial option.
5. Financial engineering techniques.

Question 30

Example of Investment Timing Option

Answer 30

If demand is low, we won’t implement project. If we wait, the up-front cost and cash flows will stay the same, except they will be shifted ahead by a year.

Question 31

Qualitative Assessment

Answer 31

The value of any real option increases if:
- The underlying project is very risky
- There is a long time before you must exercise the option.