Test prep Flashcards
Explain the properties that capital budgeting techniques should satisfy in order to maximise the investors’ return.
We assume that the stream of a project’s cash flows and cost of capital are
known, CMs are perfect.
Properties:
(i) All cash flows should be considered and discounted at the opportunity cost of funds
(ii) Select a project that maximises shareholders’ wealth from a set of
mutually exclusive projects (vs. independent, contingent)
(iii) Value-additivity principle: Mangers should consider one project independently from all others
Define four popular budgeting techniques used by managers and discuss whether they satisfy
the properties that maximise investors’ wealth. 1
- Payback Method. Considors shortest payback period. Does not consider all cash flows and fails to discount them, so rejected due to violating discounting property.
Define four popular budgeting techniques used by managers and discuss whether they satisfy
the properties that maximise investors’ wealth. 3
- Accounting Rate of Return, Average after tex accounting profit divided by initial outlay.
Considers accounting profit rather than cash flows and fails to discount them.
Rejected as it violates property i.
Define four popular budgeting techniques used by managers and discuss whether they satisfy
the properties that maximise investors’ wealth. 2
- NPV. The NPV criterion accepts projects that have the greatest NPV (> 0),
where NPV is computed by discounting the cash
ows (CF) at the rm’s
opportunity cost of capital (k)
Correct rule for capital budgeting purposes.
Define four popular budgeting techniques used by managers and discuss whether they satisfy
the properties that maximise investors’ wealth. 4
- IRR. The IRR criterion accepts projects that have the greatest IRR(> k): the
rate that equates the present value of the cash in
owes and out owes such that NPV (IRR) = 0
IRR could be a correct decision rule.
