Midterm 3 Part 3 Flashcards
True or False: Capital budgeting is one of the most important decisions made by management
True
What is the point of wise capital budgeting?
You are trying to maximize owner wealth and bring more value to the firm.
What is capital budgeting?
It is the decision making that determines how funds are allocated. Which projects should you invest in? How should you finance your company? etc.
Your decisions should always keep in mind that you are trying to gain something back that’s worth MORE than what you’re giving up.
It is the process of planning and budgeting for long-term assets
True or False: The current standings of a firm were determined in the past by decisions made by company managers decades ago.
True
They used capital budgeting to plan for long-term assets and decided how the firm would end up (if they planned well).
What are the decision making criteria for capital budgeting?
- Include all cash flows during the life of the project
- Consider the TVM
- Incorporate the RRR and risk of an asset
Why is capital budgeting also a useful tool for entrepreneurs?
They use pro forma reports to show what their company SHOULD look like to potential investors based on their capital budgeting structure
What are the three methods for evaluating potential capital projects?
- Payback
- NPV
- IRR
What does NPV stand for?
Net present value
What does IRR stand for?
Internal rate of return
Which is the preferred evaluation technique? and why?
NPV, because it doesn’t have the serious drawbacks of the other two.
What are other names for corporate finance?
Financial management, business finance, managerial finance
True or False: Quantitative finance is another name for corporate finance
False
Examples of an institution’s setting:
Insurance Company, Pension company, Consumer bank, Commercial bank
Examples of areas that an asset manager can invest in:
Real Estate, Mutual funds, venture capital
True or False: Asset managers can invest in PP&E
False
What are the three sub-specialties of finance?
- Institutions
- Investments
- Corporate finance
Is real estate a sub specialty of finance?
No, that’s a whole other ball game
What three key attributes should you evaluation model take into account?
- Considers ALL cash flows
- Considers the timing of those cash flows (TVM)
- It should account for various levels of risk using return
True or False: All cash flows are positive
False
Does the evaluation method need to consider ALL cash flows in the future, both positive and negative?
YES
True or False: The length of the period equals the life of the project
True
Why does our evaluation method need to consider the timing of the cash flows?
Because a dollar today is worth more than a dollar tomorrow. Money’s value changes over time.
The money we receive down the line may not be worth the money we are giving up today.
True or False: Risk and return are directly correlated
True
Who typically uses the payback method?
Small businesses
Which is the most simple evaluation method?
Payback
What is the payback period?
The number of years it takes to pay back the initial investment (or to make that money back)
How do managers decide whether to accept the payback period as a good investment?
They compare it to some arbitrary standard, usually in-house number set by management
What are the major flaws and failures of the payback method?
- It’s too subject to subjectivity (managers can set whatever arbitrary number they want)
- There’s no way to determine a standard cutoff that is actually bringing value to the company.
Meaning, it may be accepting bad projects and rejecting good projects.
How does the payback method fail to meet all three evaluating criteria?
- It doesn’t look at all CF, just the ones up until the initial investment is paid off.
- It does not discount Future CF back to PV
- It doesn’t measure risk and return at all, just the number of years until payback. They wouldn’t know if they were about to invest in a highly risky project.
Why is the payback method useful even with all its flaws?
Because it’s a quick and dirty way to get information without doing a bunch of analysis, it gives you some basic information quickly, good for small businesses.
True or False: The Payback method works best when it is used as a precursor of better methods and looked at with a grain of salt.
True.
What is the NPV?
It is the net value (sum) of all future cash flows discounted back to the present minus the initial cost of the project.
What does it mean if the NPV is greater than 0?
That the future cash flows are greater than the cost
Is NPV expressed in dollars or percentage?
Dollars
Is IRR expressed in dollars or percentage?
Percentage
What does it mean if the NPV is less than zero?
That we are losing value, the cash flows do not exceed the amount we’re spending on the investment. BAD investment.
NPV Decision Rule
+ NPV means accept project
- NPV means reject project
True or False: The NPV must be greater than the initial outflow to be a good investment
False!
The present values of the CFs need to be greater than the initial outlay. The NPV needs to be greater than 0.
How do you use the WACC to solve for NPV?
The WACC solution is the discount rate that needs to be applied to the NPV equation.
How do you calculate the NPV of stocks?
You don’t. Because there’s no ending date.
What is related to the NPV?
The profitability index
What is one of the issues of NPV?
We don’t have a percentage value for the return (we only get a $$ value)
What is the purpose of the Profitability index?
It helps you interpret the NPV by providing you with a percentage
How is the PI different from the NPV?
Instead of subtracting the IO, we divide by it after we’ve calculated the PV of all future cash flows
How do you calculate the IP in a financial calculator?
You use the same function (7 NPV) but set the rate to 0. Then once you have the number, you divide it by the IO
What is the decision rule for PI?
If PI > 1, accept the project
If PI < 1, reject the project
What does IRR stand for?
Internal rate of return
True or False: The IRR is the discount rate that makes the NPV equal to zero
TRUE
True or False: it is better to have a high IRR
TRUE
Decision rule of IRR
If the IRR is greater than the discount rate, then the project is assumed to be profitable. ACCEPT
True or False: The IRR is the rate of return companies earn on their capital projects
True
True or False: The IRR equation solves for the discount rate of the NPV equation
True
More or less anyway, slight difference because you’re not subtracting the IO, you’re setting the equation = to it.
True or False: The YTM is the IRR of a bond
TRUE
What is one of the problems with IRR?
It’s not completely accurate because you’re essentially coming up with a bunch of guesses of the discount rate that you THINK will set the equation equal to 0. The calculator is just giving you the best guess.
What do you compare the IRR to?
The required rate of return
When do you accept the project after checking IRR? What value is an acceptable value?
If the IRR is greater than the RRR.
Hurdle Rate
It is the RRR when discussing IRR. It is the rate that the IRR must be compared to, so you must calculate it or you won’t understand the IRR in proper context.
Capital constrained environment
Real life. Businesses can’t afford every opportunity. You have to weigh and choose the best ones
True or False: The IRR can be directly compared across all projects.
FALSE
Should you look at the IRR or the NPV when deciding which projects to accept?
Both, but prefer the NPV
Conventional Cash flow
all cash flows after the IO are positive
Unconventional Cash Flows
Cash flows are sometimes negative, sometimes positive
True or False: The IRR works with unconventional cash flows
FALSE
Why can’t the IRR calculate unconventional cash flow streams
Because every time there’s a sign change, there is a possibility of calculating the IRR, so you can end up with multiple IRR’s for one project… which is impossible
This happens because at each of these sign changes, you could potentially set the NPV equal to 0
What is the unequal lives problem?
Different assets have different project lives, so it’s hard to compare them
What are the two solutions to the unequal lives problem?
- The replacement chain approach
- The Equivalent Annual Annuity approach (EAA)
How does the replacement chain approach work?
You use the least common multiple and basically stack the assets together.
What is VERY important to remember about the replacement chain approach?
When you stack the projects, you also have to stack the IO! So you’ll need to subtract the IO from appropriate places, maybe more than once.
What is a problem with the replacement chain approach?
It can be tedious and time consuming for projects with large LCM
What is the EAA of the project?
It’s essentially the annuity payment, so you solve for PMT in the calculator, using the regular (unaltered) parameters for both projects.
True or False: When deciding between two projects with EAA, you choose the larger number.
TRUE
What do you plug into the PV when solving for EAA?
The NPV!!
What does the EAA basically mean?
You are essentially trying to figure out the dollar amount of the benefits you will receive per year, based on the project parameters.
True or False: If the firm refuses to replace the asset when it expires, you can use the replacement chain approach to compare the values.
FALSE.
If the company refuses to replace it.. you can’t stack multiple assets together.
Why do we go with the higher EAA?
As long as the NPV is positive we go with the EAA because we typically get to reinvest sooner/make more money before we get to invest again.
When is the NPV smaller?
When Cash Flows are further in the future (because they are soooo much less in PV)
How do you solve for Initial Outlay when using the PI calculation?
The number you get BEFORE you divide by IO is the IO that will equal ONE
