Module 32.1: Capital Projects, NPV, and IRR Flashcards
What is the capital budgeting process?
process of identifying and evaluating capital projects to maximize shareholder value.
What are the four administrative steps of the capital budgeting process?
1) Idea generation - most important step in the capital budgeting process.
2) Analyzing project proposals - accept or reject a project based on expected cash flows.
3) Create firm wide capital budget - must prioritize profitable projects according to the timing of the projects cash flows
4) Monitoring decisions and conducting a post audit - compare actuals to projections and understanding the differences.
What are six examples of what capital projects could be?
1) replacement projects to maintain the business - normally made without detailed analysis
2) replacement projects for cost reduction - detailed analysis
3) expansion projects - grow the business, very detailed analysis
4) new product or market development - very detailed due to large amount of uncertainty
5) mandatory projects - safety or environmental concerns, generate little revenue
6) other projects - high risk endeavors that are hard to analyze.
What are the five key principles of capital budgeting?
1) Decisions are based on cash flows
2) Cash flows are based on opportunity costs
3) The timing of cash flows is important
4) Cash flows are analyzed on an after-tax basis
5) Financing costs are reflected in the project’s required rate of return
What are sunk costs?
costs that cannot be avoided, even if the project is not undertaken.
What are externalities?
effects that the acceptance of a project may have on other firm cash flows. cannibalization is the most frequent externality.
What is a conventional cash flow pattern vs. an unconventional cash flow pattern?
conventional is when the cash flows changes signs only once. Unconventional cash flows have more than one sign change.
What are opportunity costs?
cash flows that a firm will lose by undertaking the project under analysis.
What are independent projects vs. mutually exclusive projects?
independent means that the firm can evaluate each project on a standalone basis.
mutually exclusive means that only one project in a set of possible projects can be accepted.
What is project sequencing?
some projects must be taken in a certain order to increase opportunities in the future.
What is capital rationing?
if a firm does not have unlimited access to funds, a firm must use capital rationing and prioritize the projects that increase maximum value for shareholders.
How do you calculate NPV using a TI calculator??
1) hit CF 2nd CLR WORK to clear work
2) Initial cash outlay as a negative
3) hit down and 25 enter as outlay number 2
4) after all cash outlays are entered, hit NPV, then enter the interest rate and hit enter.
What is the IRR%? How is it calculated?
the discount rate that makes the present value of the expected incremental after-tax cash inflows equal to the initial cost of the project.
What is the decision rule for IRR?
if IRR > the required rate of return then accept
if IRR < the required rate of return then deny
