Final Exam Study Prep Flashcards
What is capital budgeting?
- Analysis of potential projects
- Long-term decisions; involve large expenditures.
- Very important to firm’s future.
Steps in Capital Budgeting
- Estimate cash flows (inflows & outflows)
- Assess risk of cash flows.
- Determine r = WACC for project.
- Evaluate cash flows.
Capital Budgeting Project Categories
- 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
Projects are independent if
The cash flows of one are unaffected by the acceptance of the other.
Projects are mutually exclusive if
The cash flows of one can be adversely impacted by the acceptance of the other.
How size can affect an NPV profile cross
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.
How can timing differences affect an NPV profile cost
Project with faster payback provides more CF in early years for reinvestment. If r is high, early CF is especially good.
Modified Internal Rate of Return (MIRR)
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.
Profitability Index
The present value of future cash flows divided by the initial cost.
What is the payback period?
The number of years required to recover a project’s cost, or how long does it take to get the business’s money back.
Strengths and Weaknesses of Payback
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.
What’s the incremental cash flow for a project
‘Corporate cash flow with the project’ minus ‘Corporate cash flow without the project’
Should you subtract interest expense or dividends when calculating CF?
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.
What is an asset’s depreciable basis?
Cost + Shipping + Installation
Why is it important to include inflation when estimating cash flows?
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.
What if you terminate a project before the asset is fully depreciated?
Basis = Original basis - Accum. Depreciation.
What does ‘risk’ mean in capital budgeting?
Measured by stdev_NPV, stdev_IRR, beta.
What three types of risk are relevant in capital budgeting?
Stand-alone risk, corporate risk, market (or beta) risk.
Stand-Alone Risk
The project’s risk if it were the firm’s only asset and there were no shareholders. Ignores both firm and shareholder diversification.
Corporate Risk
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.
Market Risk
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.
How is each type of risk used?
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.
Results of Sensitivity Analysis
Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV.
Weaknesses of Sensitivity Analysis
Does not reflect diversification. Says nothing about the likelihood of change in a variable. Ignores relationships among variables.
What is a simulation analysis?
A computerized version of scenario analysis that uses continuous probability distributions.
What is a real option?
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.
Some types of real options
Investment timing options, growth options, abandonment options, flexibility options.
What is the single most important characteristic of an option?
It does not obligate its owner to take any action. It merely gives the owner the right to buy or sell an asset.
Five Procedures for Valuing Real Options
- DCF analysis of expected cash flows, ignoring the option.
- Qualitative assessment of the real option’s value.
- Decision tree analysis.
- Standard model for a corresponding financial option.
- Financial engineering techniques.
Example of Investment Timing Option
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.
Qualitative Assessment
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.
