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Finance for HR > Finance - Exam 3 > Flashcards

Finance - Exam 3 Flashcards

1
Q

What is the most important issue in corporate finance?

A

The capital budgeting question (What long-term investments should you take on?)

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2
Q

Net Present Value definition

A

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)

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3
Q

What is the logic of capital budgeting?

A

Trying to determine whether a proposed investment or project will be worth more once it is in place than it costs.

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4
Q

An investment is worth undertaking if…

A

it creates value for its owners.

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5
Q

Capital budgeting is easy when…

A

there is a market for assets similar to the investment we are considering.

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6
Q

Capital budgeting is difficult when…

A

we cannot observe the market price for at least roughly comparable investments.

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7
Q

Discounted cash flow (DCF) valuation

A

the process of valuing an investment by discounting its future cash flows.

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8
Q

Net Present Value Rule

A

An investment should be accepted if the net present value is positive and rejected if it is negative.

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9
Q

The payback period

A

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

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10
Q

The Payback Rule

A

an investment is acceptable if its calculated payback period is less than some prespecified number of years

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11
Q

Disadvantages of the Payback Period Rule (compared to NPV)

A
  • 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.
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12
Q

Discounted payback

A

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)

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13
Q

Discounted payback rule

A

Based on the discounted payback rule, an investment is acceptable if its discounted payback is less than some prespecified number of years.

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14
Q

Advantages of Discounted Payback Rule

A
  • Includes time value of money
  • Easy to understand
  • Does not accept negative estimated NPV investments.
  • Biased toward liquidity
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15
Q

Disadvantages of Discounted Payback Rule

A
  • 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.)
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16
Q

Average Accounting Return (AAR)

A

investment’s average net income divided by its average book value.

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17
Q

Average Accounting Return Rule

A

a project is acceptable if its average accounting return exceeds a target average accounting return.

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18
Q

Advantages of AAR

A
  • Easy to calculate
  • Needed information will usually be available
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19
Q

Disadvantages of AAR

A
  • Not a true RoR (ignores TMV)
  • Uses an arbitrary benchmark cutoff rate
  • Based on accounting (book) values, not cash flows and market value.
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20
Q

Internal rate of return (IRR)

A

The discount rate that makes the NPV of an investment zero.

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21
Q

The Internal Rate of Return (IRR) rule

A

An investment is acceptable if the IRR exceeds the required return. It should be rejected otherwise.

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22
Q

IRR rule and NPV rule lead to identical decisions if these 2 conditions are met

A
  • Project’s cash flows must be conventional.
  • The project must be independent.
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23
Q

net present value profile

A

a graphical representation of the relationship between an investment’s NPVs and various discount rates

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24
Q

multiple rates of return problem

A

the possibility that more than one discount rate will make the NPV of an investment zero

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25
Q

Mutually exclusive investment decisions

A

a situation in which taking one investment prevents the taking of another

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26
Q

Advantages of IRR

A
  • Closely related to NPV (often leading to identical decisions)
  • Easy to understand and communicate
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27
Q

Disadvantages of IRR

A
  • May result in multiple answers or not deal with non-conventional cash flows
  • May lead to incorrect decisions in comparisons of mutually exclusive investments
28
Q

The Modified Internal Rate of Return (MIRR)

A

the basic idea is to modify the cash flows first and then calculate an IRR using the modified cash flows.

29
Q

Which ways can you modify the IRR?

A
  • Discounting approach
  • Investment approach
  • Combination approach
30
Q

What is the discounting approach to MIRR?

A

Discount all negative cash flows back to the present at the required return, add them to the initial cost, and then calculate the IRR.

31
Q

What is the Investment approach to MIRR?

A

Compound all cash flows (positive and negative) except the first out to the end of the project’s life and then calculate the IRR.

32
Q

What is the combination approach to MIRR?

A

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.

33
Q

The profitability index

A

(i.e., benefit-cost ratio)

the present value of an investment’s future cash flows divided by its initial cost.

34
Q

What is the profitability index for positive NPV investments?

A

Bigger than 1

35
Q

What is the profitability index for negative NPV investments?

A

Less than 1

36
Q

How do we interpret the profitability index?

A

A profitability index of 1.1 tells us that, per dollar invested, $1.10 in value or $.10 in NPV results.

37
Q

Advantages of Profitability Index

A
  • Closely related to NPV
  • Easy to understand and communicate
  • Useful when available investment funds are limited.
38
Q

Disadvantage of Profitability Index

A
  • May lead to incorrect decisions in comparisons of mutually exclusive investments
39
Q

Relevant cash flow

A

a change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project.

40
Q

Incremental cash flows

A

the difference between a firm’s future cash flows with a project and those without the project.

41
Q

The stand-alone principle

A

the assumption that the evaluation of a project may be based on the project’s incremental cash flows.

42
Q

Sunk Cost

A

A cost that has already been incurred and cannot be removed and, therefore should not be considered in an investment decision.

43
Q

Opportunity cost

A

the most valuable alternative that is given up if a particular investment is undertaken.

44
Q

When does erosion occur?

A

when the cash flows of a new project come at the expense of a firm’s existing projects.

45
Q

Are other financing costs (i.e. dividends, principal repayment) considered when analyzing a proposed investment?

A

No

46
Q

Do we look at before tax or after tax cash flows?

A

After tax- because taxes are a cash outflow

47
Q

Pro forma financial statements

A

projection of future years’ operations

48
Q

Depreciation

A

Noncash deductible and has cash flow consequences only because it influences the tax bill.

49
Q

Accelerated cost recovery system (ACRS)

A

depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications.

50
Q

Modified ACRS depreciation (MACRS)

A

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.

51
Q

Equivalent annual Cost (EAC)

A

the present value of a project’s costs calculated on an annual basis.

52
Q

When we say something like, “The projected cash flow in Year 4 is $700,” what exactly do we mean?

A

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.

53
Q

Forecasting risk (i.e., estimation risk)

A

the possibility that errors in projected cash flows will lead to incorrect decisions.

54
Q

What does Scenario Analysis determine?

A

what happens to NPV estimates when we ask what-if questions.

55
Q

Sensitivity analysis

A

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.

56
Q

Simulation analysis

A

combination of scenario and sensitivity analysis, wherein we allow all items to vary at the same time

57
Q

What factors are used in Break-even analysis?

A
  • Sales volume
  • Variable costs
  • Fixed costs
  • Total costs
58
Q

Accounting Break-Even

A

the sales level that results in zero project net income

59
Q

Cash break-even

A

the sales level that results in a zero operating cash flow

60
Q

Financial break-even

A

the sales level that results in a zero NPV

61
Q

Operating leverage

A

the degree to which a firm or project relies on fixed costs

High operative leverage = heavy investment in PPE

62
Q

degree of operating leverage (DOL)

A

the percentage change in operating cash flow relative to the percentage change in quantity sold.

63
Q

When does Capital rationing exist?

A

if a firm has positive NPV projects but cannot find the necessary financing

64
Q

When does Soft rationing occur?

A

when business units are allocated a certain amount of financing for capital budgeting (i.e. corp as a whole is not short of capital)

65
Q

When does Hard rationing occur?

A

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

Finance for HR (1 decks)

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