Finance Part 2 - Chapter 02 Flashcards
opportunity cost
the cost associated with alt uses of the same funds
example of opportunity cost
if money is used for one investment, it is no longer available for other uses, creating an opportunity cost
why does an investment have an o.c. rate even when the funds employed have no explicit cost?
money could be used for another investment
O.C. applies to all investments no matter what
How are o.c. rates established?
the rate applied to an investment case flows is the rate that could be earned on all alt investments of similar risks, primary determinant is the riskiness of the cashflows being discounted
Does the O.C. rate depend on the source of the investment funds?
No, it depends only on the riskiness of those cash flows and returns available on alt investments of similar risk
Normal (Stated) Int Rate
the int rate stated in a debt contract, it does not reflect the effect of any compounding that occurs more frequently than annually
Effective Annual Rate
the int rate that under annual compounding, produces the same FV as was produced by more frequent compound
Periodic Interest Rate
in the time value of money analysis, the interest rate per period, example, 2% quarterly int, which equals an 8% annual rate
What changes must be made in the calculations to determine the FV of an amt being compounded at 8% semi and one being compounded annually at 8%?
I would need to be divided by 2
N would need to be multiplied by 2
Why is semi annual compounding better than annual from an investor standpoint?
earned more money
interest on interest is being earned more frequently
How does EAR differ from the stated rate?
It produces the same FV as stated rate, but is always annual compounding
How does the periodic rate differ from stated rate?
It reflects compounding and a different # of periods added up to find the rate per period
amortized
(installment loan) loan that is repaid in equal periodic amts that include both principal and interest payments
When constructing an amortization schedule, how is the periodic payment amount calculated?
must be equal periods, equal installments
take the rate and loan amount
Does the periodic payment remain constant over time?
yes, but only until it has been paid off
Do the principle and interest components remain constant overtime?
No because you are paying off a loan, int goes down, repayment of prin goes up
Capital budget Decisions
the process of selecting a business capital ( long term asset) investment
What is the primary advantage of classifying capital projects?
classify by size and importance
ensures both the lowest possible financing costs and availability of funds, analyze compared to similar projects
What are some typical classifications
mandatory replacement, expansion of existing services, safety or environmental projects
What role does size ( cost ) play in classification?
With each class, they are sorted by size, larger projects require more analyses and approval at higher levels
What is the role of the financial analyses in capital budgeting decision making with for-profit firms?
its clear, max owner wealth, only take on projects that are going to benefit the owner
Why is project financial analysis important in not-for-profit businesses?
providing high quality, cost effective services
provide goods for everyone, but make sure they are earning a profit
What are the four steps of capital budgeting financial analysis?
- estimate project cash flows
- assess riskiness of the est cast flows
- estimate the projects cost of capital
- assess the financial impact of the project
Incremental Cash Flow
a cash flow that arises solely from a project that is being evaluated and hence should be included in the project analysis
Terminal Value
the estimate of the value of the cash flows beyond the truncation point when a project’s cash flows are arbitrarily truncated
Salvage Value
the expected market value of an asset ( project ) at the end of its useful life
Sunk Cost
a cost that already occurred or is irrevocably committed, should not be included in project analysis
Non Incremental Cash Flow
A cash flow that does not stem solely from a project that is being evaluated
Strategic Value
the value of future investment opportunities that can be undertaken only if the project currently under consideration is accepted
Cash Flow Vs Accounting Income
a business true profitability depends on its cash flows and not on income as reported in accordance with GAAP
Cash Flow Timing
must account for the timing of cash flows, should be analyzed exactly as they occur
Project Life
one of the first decisions that must be made, a c.f. forecast should extend for the full life of the project, most organizations set an arbitrary limit on the project life
Effects on existing business lines
must consider the effects of the project under consideration on the firm’s existing business lines
Shipping, installation, and related costs
must take in cost beyond how much new equipment costs
change in current accounts
increase in current assets must be financed, same with fixed assets, impacted on changes must be recognized in capital budgeting analysis
Inflation Effects
inflation can effect profitability, so it must be considered, embedded in corp cost of capital
“Ignoring inflation effects and strategic value can result in overstating a projects financial attractiveness”
must take everything into consideration
current project must be accepted
ignoring inflation effects will lead to a not correct profitability
Payback Period
The number of years it takes for a business to recover its investment in a project without considering the time value of money
Return on ivestment
the est fin return on an investment. in capital budgeting analysis, ROI can be measured either in dollars or percentage (rate of ) return
Post audit
the feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations
Why are post audits important to the efficiency of a business?
improves forecasts, develop historical risk data, improve operations, and reduces losses
Can capital budgeting tools be used in diff settings?
they can use the tools to make all sorts of decisions including whether or not to divest assets and reduce staff
how to calculate NPV
find the PV of each net cash flow and sum the present values, if negative, project is unprofitable
How to calculate IRR
the discount rate that forces the NPV to equal 0
What are the benefits of payback?
you figure out how long its going to take to make money or pay something off. can compare it to others
What are payback deficiencies when used as the primary evaluation tool?
payback ignores all cash flows that occur after the payback period
ignores the o.c. costs associated with the capital employed
How is a project cash flow analysis constructed?
you figure out the expense of what you are buying and then the cash inflows and outflows received over time. you calculate that into a chart and find the net cash flow at the end of each year until the project period is over
what are the key differences in cash flow analyses performed by investor owned and not for profit businesses?
investor owned has to pay a certain tax that not for profit has to pay
