Finance Week 7 Flashcards
What is the role of financial managers?
To make investment and financing decisions
What are investments/ capital budgeting decision?
Should a firm invest in a new project? Which project? Should a firm replace a machine?
What is used to determined whether a financial manager should invest in a new project or not?
The NPV- the net present value
Why do Financial managers need to consider the NPV before an investment?
FM need to invest in projects that contribute positively to shareholders wealth because the goal of a financial manager is to maximize shareholders wealth
What is the NPV?
It is the present value of a project’s future payoffs minus the present value of the investment costs. It shows ho a project contributes to shareholders wealth: NPV = PV (payoffs) - PV (investment costs).
What is the NPV rule?
FM should invest in a new project if it has a positive NPV as this means it positively contributes to shareholders wealth. If NPV > 0 then invest in the new project.
What should a financial manager do if there are mutually exclusive investment projects?
A FM should choose the project with the higher NPV as this contributes more to shareholders wealth
What other capital budgeting rules could a FM use and what is the disadvantage of using these?
FM could use internal rate of return rule, profitability index rule and payback period rule- these however do not account for the TMV
What is the internal rate of return rule?
This compares the return of a project to the opportunity cost of capital to decide whether to invest or not. IRR of investment project is the interest rate that makes NPV = 0. C0 + C1/ (1+IRR) + C2/ (1+IRR)2+…=0. The opportunity cost of capital is the expected rate of return the FM gives up by investing in project rather than investing in comparable investments traded on the financial market. Rule is to invest in project if IRR > opportunity cost of capital. Problems: NPV easier, may recommend projects with higher IRR but lower NPV, rule assumes can reinvest cashflows at IRR but you can only invest them at discount rate
What is the profitability index rule?
The NPV of the project / initial investment. It is useful for firms with limited amount of funds for investment opportunity’s as it measures benefits realized per dollar of initial investment. Rule- invest in projects with +ve PI and highest. Problem- may recommend project with higher PI but lower NPV
What is the payback period rule?
Compare paybacks period of project to specific number of years to decide whether to invest or not. it is the # years it takes for payoffs to cover initial investment costs. Problems- payback period rule ignores TMV, ignores cashflows after cutoff year and may recommend project with -ve NPV.
How do you decide whether to invest in a project now or later?
Look at investment timing decisions as if both investments mutually exclusive and choose project with the higher NPV that will contribute more +vely to shareholders wealth
What if projects have different lives, how do you compare which investment is better?
Use the EAA rule for investment decisions with different lives. EAA converts NPV of a project into annuity payments over life of project. So first find the NPV then use this to find the EAA. EAA * (1/r - 1/r *(1+r)t) = NPV. EAA is the cashflow per period with the same PV as the project. Project with a higher EAA is better
What do you use when deciding whether to replace an old machine or not?
The EAA rule
What if the question is only giving costs?
A higher EAA cost means it is more expensive.
