M9 Financial Decision Models: Part 2

Question 1

IRR relationship to PV Factor

Answer 1

INVERSE
If IRR increases, PV decreases

PV Factor = 1 / (1 +IRR) ^T

Question 2

Effect on the Financial Statements when companies decide to borrow to buy/ finance lease

Answer 2

Debt increases so D/E increases
EBIT/IE - interest increases so times interest earned decreases
Credit rating decreases (more debt = more risky)

Question 3

Effect on the Financial Statements when companies decide to go with an operating lease (ST 12 months or less)

Answer 3

Debt decreases so D/E decreases

Appear less risky, thus credit rating increases

Question 4

The expected rate of return of a project and is sometimes called the time-adjusted rate of return

Answer 4

Internal Rate of Return (IRR)

“single” discount rate

Question 5

What is the objective of IRR?

Answer 5

Determines the PV and related interest rate that yields an NPV equal to 0 (in other words the PV of the after-tax net cash flows equals the initial investment on the project).
Targets the discount rate, focusing the decision on the percentage to see if it will be greater than the hurdle rate
IRR > WACC (Hurdle rate) = ACCEPT decision

Question 6

The time required for the net after-tax operating cash inflows to recover the initial investment in a project

Answer 6

payback period

Question 7

What does the payback period method focus decisions makers on? 2 Advantages of the method?
Limitations?

Answer 7

Liquidity and risk
Greater the risk = shorter the payback period
Lower the better
ADVANTAGES
1) Easy to use and understand
2) Emphasis on liquidity and management on return of principal
LIMITATIONS
1) ignores time value of money
2) cash flows AFTER initial investment is recovered is ignored
3) reinvestment ignored
4) Project profitability ignored

Question 8

How to find the payback period if it’s not even amount of cash flows to total? (partial years)

Answer 8

Check if logical answer first but if not
(Initial investment - amount calculated evenly)
—————————————————————–
amount of next full year
= should get an amount less than 1

Question 9

alternative method to the payback method that considers the time value of money

Answer 9

DISCOUTNED payback method

*use discounted cash flows in the calculations so need PV factors

Question 10

If not given in the problem, how do you calculate the PV factor of $1? (annuity due = beginning of period)

Wording: What is factor for the PV of $1 to be received two years in the future at an interest rate of x?

Answer 10

1 / (1+r)^n

r= return %
n = period in years

Question 11

If not given in the problem, how do you calculate the PV factor of ordinary annuity? (ordinary annuity = end of period)

Wording: What is the factor for the PV of $1 to be received in each of the next 3 years at x interest rate?

Answer 11

Step 1: find PV factor 1/(1+r)^n

Step 2: (1-PV factor) / r = PVFOA

Question 12

If not given in the problem, how do you calculate the FV Factor?

Answer 12

(1+r)^n

Question 13

IRR formula

Answer 13

Net incremental investment (investment rcvd) / Net annual cash flows

*AFTER TAX cash flows