Section E: Investment Decision

Question 1

Payback Period is calculated by

Answer 1

Cash outflow / Cash inflow = years to payback

Where cash outflow is initial investment, and
Cash inflow is the net yearly cash added (less taxes)

Question 2

Calculate NPV on calclator

Answer 2

PV - initial investment = NPV

I, N, PMT, FV > CPT PV

I = interest/hurdle rate
N= years of project
PMT = After-tax cash flow
FV= salvage value, working capital returned

Question 3

Calculate IRR

Answer 3

N, PV, PMT, FV > CPT I/YR

N = # of periods
PV = investment + working capital (this should be negative number)
PMT = After-tax income generated
FV = working capital returned

Question 4

Working capital

Answer 4

Operating liquidity available to firm.
(Operating current assets - operating current liabilities)

Question 5

How does a firm develop a hurdle rate?

Answer 5

Using WACC & may adjust rate for riskier projects by raising the discount rate

Question 6

Payback Period vs. Discounted Payback Period

Answer 6

Both calculate length of time to break even on a project.
The discounted payback period takes into account the time value of money

Question 7

A real option is based on a _______________

Answer 7

Business initiative

It gives the holder the right, but not the obligation, to undertake a business initiative, such as expanding, contracting, delaying, or scaling back.

Question 8

A financial derivative ____________

Answer 8

Gives the holder the right, but not the obligation, to purchase or sell financial assets - shares of stock, oil, gold

Question 9

Stages in developing a capital budget for a project:

Answer 9

1. Initial Investment
2. Increase in working capital
3. Incremental operating cash flows
4. Release of working capital
5. Terminal cash flow