M8 Financial Decision Models: Part 1

Question 1

Process for evaluating and selecting the LONG-TERM investment projects of the firm

Answer 1

Capital Budgeting

Question 2

How to calculate PRETAX cash inflows?

Answer 2

inflow * (1-T)

*Tax rate - think you get to keep the nontaxed portion, government keeps the taxed portion

Question 3

How to calculate depreciation taxes

Answer 3

Depreciation * Tax rate

*TAX SHIELD

Question 4

techniques that use time value of money concepts to measure the PV of cash inflows and outflows expected from a project

Answer 4

DCF valuation methods (Discount Cash Flow)

1) NPV
2) IRR (Module 9)

Question 5

What is a limitation of the Discounted Cash flow technique(s)?

Answer 5

*they DO consider the time value of money

**however, they frequently use a single interest rate assumption which is pretty unrealistic since actual interest rates tend to fluctuate. This is why the NPV method is SUPERIOR to IRR because NPV can apply different discount rates

Question 6

PASS KEY How to calculate the discounted cash flow NPV method

Answer 6

Step 1: Calculate After tax cash flows = annual net cash flow * (1-T)
Step 2: Add depreciation benefit = Depreciation * T
Step 3: Multiply result by appropriate PV of an annuity (assuming same cash flows)
Step 4: Subtract initial cash outflow (or initial investment including shipping, installation, etc.)

Question 7

If NPV is positive, what is the result? Two assumptions about PI and hurdle?

Answer 7

Make investment
Sum of PVFCFs > cost
IRR > hurdle
PI (Profitability Index) > 1

Question 8

What discounted cash flow method does NOT allow adjustments to interest rates for required return?

Answer 8

IRR

Question 9

What is a limitation on NPV method?

Answer 9

does not provide the TRUE rate of return on the investment - it just shows whether an investment will earn the “hurdle rate” used in the calculation

Question 10

Concept that describes how limited investment resources are considered as part of investment ranking and selection decisions

Answer 10

Capital Rationing

Question 11

What can be used to help rank decisions?

Answer 11

Profitability Index
*want > 1 and the higher the better

capital rationing

Question 12

Formula for profitability index?

Answer 12

PVFCFs / Cost of initial investment

Question 13

What PV factor do you use if it’s a ONE time cash flow?

Answer 13

PV of $1 (i.e. terminal year, salvage value, etc.)

Question 14

What PV factor do you use if it’s the same cash flows annually?

Answer 14

PV of ANNUITY

Question 15

The NPV of a proposed investment is negative; therefore, the discount rate used must be ?

Answer 15

Greater than the project’s internal rate of return (IRR)

Question 16

What is the potential benefit lost by selecting a particular course of action?

Answer 16

Opportunity cost