Midterm 1 Study Terms Flashcards
what is MARR
Minimum acceptable rate of return
how is MARR viewed?
the interest rate that must be earned for any project to be accepted
what is NPV?
the difference between the present value of cash inflows and the present value of cash outflows
what is IRR
Internal rate of return
how is IRR viewed
the interest rate (annual effective rate) at which a project just breaks even
differences between independent and mutually exclusive projects
independent: two projects if expected costs and benefits of each project do not depend on whether the other one is chosen
mutual: process in choosing one, all other alternatives are exluded
decision rule for NPV
if NPV >0, accept the investment
if NPV = 0, remain indifferent
if NPV<0, reject the investment
decision rule for IRR
IRR > MARR, accept the investment (NPV is positive)
IRR = MARR, remain indifferent (NPV is zero)
IRR < MARR, reject the investment (NPV is negative)
what is capital budgeting
The process to decide whether to invest in specific capital assets or projects.
what are some alternative methods to capital budgeting?
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Net Present Value (NPV)
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Internal Rate of Return (IRR)
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Modified IRR (MIRR)
what are the 2 conditions where IRR and NPV lead to identical decisions?
the project’s cash flows must be conventional, i.e. 1stCF is negative, and all the rest CFs are positive
projects must be independent
pitfalls of the IRR method?
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More than one IRR can be found for projects with alternating positive and negative cash flows, which leads to confusion and ambiguity.
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IRR assumes that interim positive cash flows are reinvested at the same rate of return as the project’s return.
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This is usually an unrealistic scenario, and a more likely situation is that the funds will be reinvested at a rate closer to the firm’s cost of capital.
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The IRR often gives a more optimistic picture of the projects under evaluation.
capital budgeting process
- Identify and estimate the relevant incremental after-tax cash flows.
- Determine the appropriate discount rate
(Weighted Average Cost of Capital –WAAC). - Calculate the Net Present Value.
- Use other capital budgeting criteria if needed.
identifying cash flows process
- Identify and estimate the actual cash flows rather than accounting profits-depreciation is non-cash expenses, not included in the cash flows.
- Determine the marginal or incremental cash flows -not including the cash flows that exist no matter whether or not the project is undertaken.
- Sunk costs are irrelevant for the decision.
Any costs that exist regardless of the investment decision. - External costs are often difficult to estimate and are not included in the quantitate analysis.
what is inflation?
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Inflation is the general rise in the price of goods & services over time.
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It can also be described as a decrease in the purchasing power of money over time.
what is a price index?
▪ A price index relates the average price of a given set of goods in some time period to the average price of the same set of goods in another period.
what is the most common measurement of inflation
CPI (consumer price index)
what are actual dollars?
- “Actual” dollars are the actual dollar amounts that are changing hands-expressed in the monetary units at the time the cash flows occur –also called nominal dollars.
what are real dollars
- “Real” dollars are actual dollars expressed in terms of the value ata specific time, usually present day
what are the two methods for dealing with inflation?
- nominal method
- real method
what is the nominal method?
Both the discount rate and cash flows be adjusted to reflect the impact of inflation
what is the real method
Estimates the cash flows based on present-day dollars (real dollars) and use the real required rate of return to discount the cash flows
what is a way to describe assets?
what has been invested in (tools, prepaid stuff, fuel etc.)
what is a way to describe liabilities
non-owner financing (borrowing, creditors)
