Finance - Exam 3 Flashcards
What is the most important issue in corporate finance?
The capital budgeting question (What long-term investments should you take on?)
Net Present Value definition
the difference between an investment’s market value and its cost (i.e., a measure of how much value is created or added today by undertaking an investment)
What is the logic of capital budgeting?
Trying to determine whether a proposed investment or project will be worth more once it is in place than it costs.
An investment is worth undertaking if…
it creates value for its owners.
Capital budgeting is easy when…
there is a market for assets similar to the investment we are considering.
Capital budgeting is difficult when…
we cannot observe the market price for at least roughly comparable investments.
Discounted cash flow (DCF) valuation
the process of valuing an investment by discounting its future cash flows.
Net Present Value Rule
An investment should be accepted if the net present value is positive and rejected if it is negative.
The payback period
the amount of time required for an investment to generate cash flows sufficient to recover its initial cost
The Payback Rule
an investment is acceptable if its calculated payback period is less than some prespecified number of years
Disadvantages of the Payback Period Rule (compared to NPV)
- The time value of money is completely ignored.
- Payback rule fails to consider any risk differences.
- There is no economic rationale for looking at payback in the first place, so we have no guide for picking the cutoff.
- Doesn’t ask the right question - The relevant issue is the impact an investment will have on the value of the stock, not how long it takes to recover the initial investment.
Discounted payback
the length of time required for an investment’s discounted cash flows to equal its initial cost
(i.e. time it takes to break even in an economical or financial sense)
Discounted payback rule
Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.
Advantages of Discounted Payback Rule
- Includes time value of money
- Easy to understand
- Does not accept negative estimated NPV investments.
- Biased toward liquidity
Disadvantages of Discounted Payback Rule
- May reject positive NPV investments
- Requires an arbitrary cutoff point
- Ignores cash flows beyond cutoff date
- Biased against long-term investments (R&D, new projects, etc.)
Average Accounting Return (AAR)
investment’s average net income divided by its average book value.
Average Accounting Return Rule
a project is acceptable if its average accounting return exceeds a target average accounting return.
Advantages of AAR
- Easy to calculate
- Needed information will usually be available
Disadvantages of AAR
- Not a true RoR (ignores TMV)
- Uses an arbitrary benchmark cutoff rate
- Based on accounting (book) values, not cash flows and market value.
Internal rate of return (IRR)
The discount rate that makes the NPV of an investment zero.
The Internal Rate of Return (IRR) rule
An investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.
IRR rule and NPV rule lead to identical decisions if these 2 conditions are met
- Project’s cash flows must be conventional.
- The project must be independent.
net present value profile
a graphical representation of the relationship between an investment’s NPVs and various discount rates
multiple rates of return problem
the possibility that more than one discount rate will make the NPV of an investment zero
Mutually exclusive investment decisions
a situation in which taking one investment prevents the taking of another
Advantages of IRR
- Closely related to NPV (often leading to identical decisions)
- Easy to understand and communicate
Disadvantages of IRR
- May result in multiple answers or not deal with non-conventional cash flows
- May lead to incorrect decisions in comparisons of mutually exclusive investments
The Modified Internal Rate of Return (MIRR)
the basic idea is to modify the cash flows first and then calculate an IRR using the modified cash flows.
Which ways can you modify the IRR?
- Discounting approach
- Investment approach
- Combination approach
What is the discounting approach to MIRR?
Discount all negative cash flows back to the present at the required return, add them to the initial cost, and then calculate the IRR.
What is the Investment approach to MIRR?
Compound all cash flows (positive and negative) except the first out to the end of the project’s life and then calculate the IRR.
What is the combination approach to MIRR?
Blends Discounting and Investment approaches.
Negative cash flows are discounted back to the present, and positive cash flows are compounded to the end of the project.
The profitability index
(i.e., benefit-cost ratio)
the present value of an investment’s future cash flows divided by its initial cost.
What is the profitability index for positive NPV investments?
Bigger than 1
What is the profitability index for negative NPV investments?
Less than 1
How do we interpret the profitability index?
A profitability index of 1.1 tells us that, per dollar invested, $1.10 in value or $.10 in NPV results.
Advantages of Profitability Index
- Closely related to NPV
- Easy to understand and communicate
- Useful when available investment funds are limited.
Disadvantage of Profitability Index
- May lead to incorrect decisions in comparisons of mutually exclusive investments
Relevant cash flow
a change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project.
Incremental cash flows
the difference between a firm’s future cash flows with a project and those without the project.
The stand-alone principle
the assumption that the evaluation of a project may be based on the project’s incremental cash flows.
Sunk Cost
A cost that has already been incurred and cannot be removed and, therefore should not be considered in an investment decision.
Opportunity cost
the most valuable alternative that is given up if a particular investment is undertaken.
When does erosion occur?
when the cash flows of a new project come at the expense of a firm’s existing projects.
Are other financing costs (i.e. dividends, principal repayment) considered when analyzing a proposed investment?
No
Do we look at before tax or after tax cash flows?
After tax- because taxes are a cash outflow
Pro forma financial statements
projection of future years’ operations
Depreciation
Noncash deductible and has cash flow consequences only because it influences the tax bill.
Accelerated cost recovery system (ACRS)
depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications.
Modified ACRS depreciation (MACRS)
Characterized by every asset being assigned to a particular class based on asset’s tax life).
Once an asset’s tax life is determined, depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage.
Equivalent annual Cost (EAC)
the present value of a project’s costs calculated on an annual basis.
When we say something like, “The projected cash flow in Year 4 is $700,” what exactly do we mean?
We do not necessarily think cash flow will actually be $700, but rather if we took all the possible cash flows that could occur in four years and averaged them, the result would be $700.
Forecasting risk (i.e., estimation risk)
the possibility that errors in projected cash flows will lead to incorrect decisions.
What does Scenario Analysis determine?
what happens to NPV estimates when we ask what-if questions.
Sensitivity analysis
Investigates what happens to NPV when only one variable is changed.
With sensitivity analysis, we let only one variable change, but we let it take on many values.
Simulation analysis
combination of scenario and sensitivity analysis, wherein we allow all items to vary at the same time
What factors are used in Break-even analysis?
- Sales volume
- Variable costs
- Fixed costs
- Total costs
Accounting Break-Even
the sales level that results in zero project net income
Cash break-even
the sales level that results in a zero operating cash flow
Financial break-even
the sales level that results in a zero NPV
Operating leverage
the degree to which a firm or project relies on fixed costs
High operative leverage = heavy investment in PPE
degree of operating leverage (DOL)
the percentage change in operating cash flow relative to the percentage change in quantity sold.
When does Capital rationing exist?
if a firm has positive NPV projects but cannot find the necessary financing
When does Soft rationing occur?
when business units are allocated a certain amount of financing for capital budgeting (i.e. corp as a whole is not short of capital)
When does Hard rationing occur?
when a business cannot raise financing for a project under any circumstances (i.e. financial distress, firm unable to raise capital without violation of previous agreements)
DCF analysis breaks down when hard rationing occurs
