S8: NPV, IRR, & Capital Investment Decisions

Question 1

Capital Budgeting

Answer 1

Decisions on the process of analyzing, planning, justifying, & deciding on large capital expenditures

Question 2

Relevant cash flows

Answer 2

Come as a direct consequence of a project

Question 3

Stand-alone principle

Answer 3

assumption that evaluation of a project is based on these incremental cash flows alone, treating each project as a “mini-firm” with its own income and expenses

Question 4

Relevant/incremental costs

Answer 4

Opportunity Cost, NWC, Side effects, Taxes (TONS)

Question 5

Irrelevant

Answer 5

Financing Costs, Sunk Costs (FS)

Question 6

Opportunity cost

Answer 6

The most valuable alternative that is given up

Question 7

NWC

Answer 7

Changes in current assets and liabilities due to a project

Question 8

Side effects

Answer 8

Erosion: Takes $ away from other projects, Synergy: Boosts $ of other projects

Question 9

Taxes

Answer 9

Taxes paid on cash flows generated by the project (Usually ~21%)

Question 10

Financing costs

Answer 10

Debt incurred to pursue a project (mix of debt and equity financing)

Question 11

Sunk costs

Answer 11

Costs incurred that can’t be undone (land already owned)

Question 12

Proforma statements

Answer 12

Forecasted future statements

Question 13

Proforma Income

Answer 13

Sales-Variable costs-Fixed costs-depreciation=EBIT-Taxes (but not interest)=Net Income

Question 14

OCFp

Answer 14

Operating Cash Flow from project=EBIT+Depreciation-taxes

Question 15

Proforma Cash Flows

Answer 15

Total CFp= OCFp+-NWC Change+-Capital spending/salvage value

Question 16

Net Working Capital Recovery

Answer 16

As a project winds down, its inventories, receivables, payables are closed out, freeing up original investment in working capital

Question 17

Salvage value

Answer 17

Costs of capital spending that can be recovered at the end of the project

Question 18

Accept or reject?

Answer 18

If CFp>Cost of project then it should be pursued

Question 19

Depreciation Tax Shield

Answer 19

Tax saving resulting from the depreciation deduction prior to paying income tax, because depreciation expense reduces the amount the firm needs to pay taxes on

Question 20

5 Methods of Evaluating Investments

Answer 20

Net present value (NPV), Internal Rate of Return (IRR), Payback Period, Discounted Payback Period, Profitability Index (NIPPD)

Question 21

Net Present Value (NPV)

Answer 21

The difference between an investments present value and its cost (Accept if positive)

Question 22

Internal Rate of Return (IRR)

Answer 22

The discount rate that makes the NPV of an investment equal to 0 (Accept if greater than Required Rate of Return)

Question 23

IRR Assumptions

Answer 23

1. Required Rate of Return is same as discount rate used in NPV calculations
2. Project has conventional cash flows (CFo -, remaining CF+)
3. Projects under evaluation are NOT mutually exclusive

Question 24

Unconventional Cash Flows

Answer 24

Exists when not all cash flows following initial investment are positive -> Use NPV in this case

Question 25

Mutually Exclusive

Answer 25

Pursuing one project implies that the other can't be done (have to choose one) -> Us NPV and accept higher NPV

Question 26

Multiple IRR Problem

Answer 26

Occurs when you try to compare a project with unconventional cash flows, you can get two different "correct" answers for IRR

Question 27

Payback period

Answer 27

Amount of time required to generate cash sufficient to cover its costs (Accept if payback period is less than time period chosen by firm)

Question 28

Discounted Payback period

Answer 28

Similar to payback period but discounts cash flows to PV (CF/(1+r)^t))

Question 29

Profitability Index (AKA Benefit Cost Ratio)

Answer 29

PV of CFp/Initial investment (Go through same steps used for NPV, but instead Leave CF0 as 0 and divide by that as the initial investment instead) (If PI is greater than 1 accept project)

Question 30

How does $10 move through all three financial statements?

Answer 30

A $10 increase in depreciation reduces net income by $7 (IS), increases cash flow by $3 due to tax savings, and decreases assets by $10 (BS), balanced by a $7 reduction in retained earnings and a $3 increase in cash (SCF).