Unit 4 - Intro to Finance Management and Investment Rules Flashcards
Successful companies need this to survive in the long run
Take good care of customers
2 types of decisions made by Upper Level Management in Corporations
Investment Decisions, Financing Decisions
Capital Structure Risk Management concerned with
Debt/Equity
Good Investment Decisions…
increase good Cash Flows
Good Financing Decisions… (2)
Reduce cost of Capital, to create shareholder value
Ultimate goal of Upper Level Management Decisions
Create shareholder value
Shareholders are… (1)
the owners of the corporation
The primary financial goal of any public corporation is…
to create economic value for its shareholders
Shareholders are… (2)
residual claimants
Shareholders receive money only after:
1) Suppliers have been paid
2) Wages to workers have been paid
3) Interest to bondholders have been paid
4) Taxes have been paid.
Shareholders receive money only after:
1) Suppliers have been paid
2) Wages to workers have been paid
3) Interest to bondholders have been paid
4) Taxes have been paid
If shareholders are happy…
so are the other stakeholders
Capital Budgeting
Process of determining which assets to invest in and how much to invest
- Capital Budgeting decision
- Capital expenditure decision
- Capital Investment decision
Capital Budgeting Decision Making Process Steps
Identification
Evaluation
Selection
Implementation
Identification Step
- Finding out opportunities
- Generating investment proposals
Evaluation Step
Estimating the project’s:
- Relevant cash flows
- Appropriate discount rate
Selection Step
Choosing a decision making rule (accept/reject criterion)
Implementation
Establishing an audit and a follow-up procedure
4 Identification Types
Required Investment
Replacement Investment
Expansion Investment
Diversification Investment
2 Evaluation Types
Expected Cash-flow stream
Discount rate
4 Selection Types
Net Present value
Profitability index
Internal Rate of return
Payback period
Implementation Steps
- Monitor the magnitude and timing of cash flows
- Check if the project still meets the selection criterion
- Decide on a continuation or abandonment
- Review previous steps if failure rate is high
Opportunity Cost
Rate of return you sacrifice on the next best alternative
Future Values
- The first method for deciding which option is best
- Calculates the future value of investing the payment at your opportunity cost of capital for years
Future Value Formula
FV = PV x (1+r)^t
Present Values
- More common method
- Amount of money you would need to invest today in order to duplicate some future dollar amount.
Present Value Formula
PV = FV/(1+r)^t
Rate Function Excel
=RATE(time in years, PV, FV)
Number of Periods Function Excel
=NPER(Rate, PV, FV)
Payment Function Excel
=PMT(Rate, Time, PV)
Net Present Value
Forecasting the benefits and costs of the project for period “t”.
Net Present Value Formula
NPV = C0 + (C1/1+r) + (C2/1+r^2)…
If NPV > 0
Accept Project
If NPV < 0
Reject Project
Independent
Acceptance or rejection is independent of the acceptance or rejection of other projects
Mutually Exclusive
Can accept A or B, or reject both, but cannot accept not both.
Payback period
Number of periods required for the sum of the project’s expected cash flows to equal its initial cash outlay. (time to recover investment)
Internal Rate of Return
The Discount rate that makes the net present value of the project equal to 0.
Accept the project if IRR is…
the cost of capital
Profitability Index
The present value of an investment’s future cash flows / initial cost.
Profitability Index Formula
(CF0 + NPV)/CFO
Profitability Index > 0
Accept
Problems with IRR
Multiple IRRs Can Exist
The Scale Problem
The Timing Problem
Multiple IRRs
There can be 2 or more
The Scale Problem
Depends on initial investment amount, can skew IRR
The Timing Problem
When 2 projects IRR flip over time
Crossover Rate
When project’s NPV are equal to each other
NPV versus IRR
Usually give the same decision
NPV verses IRR Exceptions
1) Non-Conventional cash flows- cash flow sign change more than once
2) Mutually exclusive projects
- Initial Investments substantially differ
- Timing of cash flows substantially differ
