Topic 1 - basic concepts about capital budgeting Flashcards
Three questions that Corporate Finance addresses
- What long-term investments should the firm choose
- How should the firm raise funds for the selected investments
- How should short-term assets be managed and financed
What’s the capital budgeting decision?
What long-term investments should the firm choose?
What’s the capital structure decision?
How should the firm raise funds for the selected investments?
The Financial Manager’s primary goal is to increase the value of the firm by
- selecting value creating projects
- making smart financing decisions
What is the agency problem
Agency relationship:
* principal hires an agent to represent his/her interest
* stockholders hire managers to run the company
Agency problem:
* conflict of interest between principal and agent
When should an investment be purchased?
When the present value of the cash inflow is greater than the cost. In other words, when the Net Present Value (NPV) is positive, the investment should be purchased
What is a perpetuity
& formula
A constant stream of cash flows that lasts forever
What is a growing perpetuity
& formula
A stream of cash flows that grows at a constant rate forever
What is an annuity
& formula
A stream of constant cash flows that lasts for a fixed number of periods
What is a growing annuity
A stream of cash flows that grows at a constant rate for a fixed number of periods
Mutually exclusive projects VS Independent projects
- Mutually exclusive projects: only ONE out of several potential projects can be chosen
- Independent projects: accepting or rejecting one project does not affect the decision of other projects
Why use NPV?
Accepting positive NPV projects benefits shareholders:
* NPV uses cash flows
* NPV uses all the cash flows of the project
* NPV discounts the cash flows properly
Reinvestment assumption: the NPV rule assumes all cash flows are reinvested at the discount rate
What is the payback period?
The number of years it takes to recover initial costs
The payback period method
Advantages and disadvantages
Disadvantages:
* ignores the time value of money
* ignores cash flows after payback period
* biased against long-term projects
* required an arbitrary acceptance criteria
* a project accepted based on the payback criteria may not have a positive NPV
Advantages:
* easy to understand
* biased toward liquidity
what is the decision rule?
accept the project if it pays back on a discounted basis within the specified time
On the IRR
- IRR: the discount rate that sets NPV to zero
- Minimum acceptance criteria: accept if the IRR exceeds the required return
- Ranking criteria: select alternative with the highest IRR
- Reinvestment assumption: all future cash flows assumed reinvested at the IRR
Advantages & disadvantages of IRR
Disadvantages:
* does not distinguish between investing and borrowing
* IRR may not exist, or there may be multiple IRRs
* problems with mutually exclusive investments
Advantages:
* easy to understand and communicate
Limitation to the average maturity period (calculating IRR manually)
it only worksif there are no negative cash flows, except the initial investment; or all values are negative, except the initial one
NPV vs IRR
- NPV & IRR will generally give the same decision about the feasibility of the project
- exceptions:
- non-conventional cash flows: cash flow signs change more than once (possible IRR inconsistency)
- mutually exclusive projects: initial investments are substantially different or timing of cash flows is substantially different
Net present value
- Difference between market value and cost
- Accept the project if the NPV is positive
- Preferred decision criterion
Internal rate of return
- Discount rate that makes NPV = 0
- Take the project if the IRR is greater than the required return
- Same decision as NPV with conventional cash flows
- IRR is unreliable with non-conventional cash flows or mutually exclusive projects
Payback period
- Length of time until initial investment is recovered
- Take the project if it pays back in some specified period
- Does not account for time value of money, and there is an arbitrary cutoff period
Discounted payback period
- Length of time until initial investment is recovered on a discounted basis
- Take the project if it pays back in some specified period
- There is an arbitrary cutoff period
