Topic 5 - Risk and Returns in Corporate Finance Flashcards
What is capital budgeting?
the process of determining which long-term investments the company should undertake
What are the 5 steps in capital budgeting?
- id potential investments
- estimate incremental cash flows (in/out)
- estimate fair rate of return given risk
- analyse and prioritise investments
- implement and monitor
What characteristics does management desire in a capital budgeting technique?
Easily applied technique that considers cash flows, the time value of money, fully accounts for risk and return, and when applied leads to higher share prices
NPV
the sum of the present values of all a projects cashflows discounted at a rate consistent with the projects risk. NPV is also the preferred method for VC
EVA
economic value added is the method of analysing capital investments which determines whether an investment produces net cash flow sufficient to cover the company’s cost of capital
State NPV decision rule
NPV > 0 , invest
NPV < 0 do not invest
How much will a share price rise if a NPV project is positive?
Divid project NPV with # of outstanding shares
NPV benefits
*focuses on cash, not accounting earnings
* makes appropriate adjustment for TMV
*can properly account for differences between projects
NPV drawbacks
- doesn’t capture managerial flexibility
*lacks some intuitive appeal compared to simpler methods
Economic Profit
A profit that exceeds a normal, competitive rate of return in an industry or line of business
What does it mean if a project has a NPV of $1m
NPV gives a direct estimate of the change in shareholder wealth resulting from a given investment and provides a straightforward way to control differences in risk among alternatives. However it does not provide a means for incorporating managerial flexibility
IRR
the compound annual rate of return on a project given its up-front costs and subsequant cash flows
IRR decision rule
if IRR > hurdle rate, accept project
if IRR < hurdle rate, reject project
IRR hurdle rate examples
cost of capital
required rate of return discount rate
IRR advantages
properly adjust for time value of money
uses cash flows rather than earnings
accounts for all cash flows
project IRR is a number with intuitive appeal
IRR disadvantages
- non conventional cash flows eg. lending v borrowing, multiple IRRs
- mutually exclusive projects eg. scale bias, timing of cash flows
What is a conventional cash flow?
A project has a conventional cash flow if the initial cash flow is negative, or all costs come first, then after all the cash flows are positive. There is a relationship between NPV and IRR for the project
What is a non-conventional cash flow
A project has a non-conventional CF when we have both inflows and outflows during the life of the investment. We have multiple IRRs and don’t know which one is relevant
NPV and IRR relationship
What is the payback period
the amount of time required for the company to recover its initial investment
advantages of payback period
- computational simplicity
- easy to understand
- focus on cash flow
disadvantages of the payback period
- does not account properly for TMV
- does not account properly for risk
- cut-off period is arbitrary
- does not lead to value maximising decisions
Discounted pay back period
the amount of time it takes for a projects discounted cash flows to recover the initial invsetment
Accounting rate of return - ARR
ROI calculated by dividing net income by the book value of assets