Financial Decision Models Flashcards
What is evaluating and selecting the long-term investment projects of the firm called?
Capital budgeting
No cash activity that produces cash benefits or obligations are considered what effect?
Indirect
What are the three stages of cash flows?
- Inception of the project
- Operations
- Disposal of the project
How to calculate the disposal of a replaced asset?
Selling Price (inflow) - Net Book Value = G/L G/L X Tax Rate = Taxes Paid (Outflow) Selling Price - Taxes Paid = Net Gain or Loss
Formula for calculating the After-Tax Cash Flows:
Pretax Cash Flow (EBT) x (1 - Tax Rate) = Inflow
Formula for calculating depreciation tax shields:
Depreciation x tax rate = inflow
The bigger the depreciation expense means…
The bigger the cash inflow / tax reduction
Techniques that use time value of money concepts to measure the present value of cash inflows and outflows expected from a project are:
Discounted Cash Flow (DCF) Valuation Methods
What is the objective of the Discounted Cash Flows (DCF) Valuation Methods?
To focus managements attention on relevant cash flows (after tax) appropriately discounted to PV
Formula to calculate the NPV:
Sum of PV future cash flows - cost = NPV
Formula to calculate interest expense:
EBIT X (1 - Tax Rate) = CFO
The steps for calculating the NPV for discounted future cash flows are:
- Calculate after tax cash flows = Net Cash Flows X (1 - Tax Rate)
- Add depreciation benefit = Depreciation X Tax Rate
- Multiply the result by appropriate present value of an annuity
- Subtract initial cash outflow
The result of the above steps is the Net Present Value
The theoretical dollar change in the market value of the firm’s equity due to the project is the
NPV
If the NPV is positive, the sum of the PV FCFs is > the Cost, then the rate of return is greater than the hurdle rate (the discount percentage used in the net present value calculation) and the investment should be made or not made?
The investment should be made
If the NPV is negative, the sum of the PV FCFs is < the Cost, then the rate of return is less than the hurdle rate (the discount percentage used in the net present value calculation) and the investment should be made or not made?
The investment should not be made
Advantages and limitations to using the NPV Method:
Advantages: flexible and can be used when there is no constant rate of return required
Disadvantages: does not provide the true rate of return on the investment
If capital is limited and must be rationed, management should
Allocate capital to the combination of projects with the maximum NPV
The formula for calculating the profitability index is:
Present value of cash flows / cost (PV) of initial investment
(One hopes the profitability index is high)
What are the two decisions when applying the NPV: Lease vs Buy Decision?
Investment decision or Financial decision
Under the investment decision, one would discount the after-tax operating cash inflows at what rate?
The firms’s weighted average cost of capital (WACC) rate
EBIT X (1 - Tax Rate)
Under the financial decision, one would discount the cash flows using what rate?
At the after-tax cost of debt
YTM X (1 - Tax Rate)
Under the financial decision, which financing option is the preferred option?
The one with the lowest NPV
As a company’s debt to equity ratio increases, it will appear to be more risky and do what to their credit rating?
Cause their credit rating to decrease
The expected rate of return on project is also called what?
The internal rate of return (IRR)
If the IRR > Hurdle Rate, accept the project
The time required for the net after-tax operating cash inflows to recover the initial investment in a project is called the:
Payback period
The payback period method focuses decision makers on what?
Liquidity and risk
It is used for risky investments. The greater the risk of the investment, the shorter the payback period that is expected/tolerated by the company.
Calculation for finding the payback period is:
Initial investment / annual annuity = payback period
The lower the payback period the better
What are some limitations to the payback period method?
Time value of money is ignored
Cash flows occurring after the initial investment is recovered are ignored
Reinvestments of cash flows is ignored
Profitability is ignored
The major difference between the payback period method and the discounted payback period method is what?
The discounted payback period method incorporated the time value of money in its calculation
