Unit 6 Decision Making Flashcards
Capital Budgeting Criteria
used to evaluate investments
NPV - net present value
IRR - Internal Rate of Return
PI - Profitability Index
NPV
difference between a projects present value of cash inflows and outflows
Indicates potential profit in today’s $ of a planned investment
Advantages of NPV
Accounts for time value of money
Determines value added to firm
Considers risk and required return
Disadvantages of NPV
Difficult to know appropriate cost of capital
Cannot be use to compare projects of different size
IRR
percentage return on an investment
The rate that would make NPV equal to 0.
Decision rule for IRR
If IRR > cost of capital, accept project
cost of capital = hurdle rate
Advantages to IRR
Easy to interpret
Considers Time Value of Money
Doesn’t need Rate of Return
Disadvantages of IRR
- Not a good indicator of value created
- Ignores mutually exclusive projects - can’t be used on its own to choose between one project or another
- Assumes Reinvestment at IRR
- Cannot Compare Projects with Different Durations
- Requires Conventional Cash Flows
NPV decision rule
If NPV is positive = accept
If NPV is negative = reject
PI
ratio of payoff to the investment amount
PI decision rule
Accept if PI > 1
Reject if PI < 1
Advantages of PI
same advantages of NPV
+ Can be used to choose between projects
Disadvantages to PI
Need cost of capital
not useful for mutually exclusive projects
Par Value
initial value of bond
value paid out at maturity
corporate US bonds usually $1000
Coupon Rate
aka coupon yield
interest rate on the bond
coupon
interest payment amount
YTM
yield to maturity
actual return on a bond when bought on the marketplace
covenants
affirmative - things bond issuer pledges to do to protect bondholders
Negative - things bond issues pledges not to do to protect bondholders
Premium
bond selling above face value
YTM is lower than coupon rate
Discount
bond selling below face value
YTM is higher than coupon rate
Common stock
equity/ownership in a firm
confers voting rights
lowest claim
no maturity
corporate governance
control issues involved in running a company (management tasks)
upside potential
unlimited potential earnings on common stock
preferred stock
aka hybrid security
some elements of equity and debt
no fixed maturity (like equity/common stock)
no voting rights
fixed payments
company may skip payments
payments must be paid before common stock dividends are paid out (cumulative)
capital investment
money use used to buy long term assets
loans, stocks, bonds
may affect short term earnings and growth
Intrinsic value
asset value determined through analysis without looking at market value
add discounted future cash flows of an asset (present value of future cash flows)
compare to market value to determine value
bond valuation
derive YTM from coupon, face value, current value
derive current value from coupon, face value, YTM
use Present Value to determine value
preferred stock valuation
perpetuity model Vps = D/kps D is dividend kps is required rate of return compare to current market value to determine if purchase is advisable
common stock valuation methods
Gordon Growth Model
based on Dividend Discount Model - calculate present value of all future dividend cash flows
Assumptions in Gordon Growth Model
Dividends paid each year
Dividends grow at constant rate forever
GGM formula
Vcs = D1/(kcs-g)
D1 is dividend paid next year
kcs is required rate of return
g is constant growth rate
Capital Asset Pricing Model
Pricing for Capital Assets
linear relationships between risk and return
beta
how the price of a security varies with market
market has beta of 1
riskless asset has beta of 0
exaggerated reaction to market by a firm is beta > 1
muted reaction to market by a firm is beta < 1
aggressive asset vs defensive asset
aggressive - beta > 1
defensive - beta < 1
CAPM formula
Ri = Rf + Bi(Rm - Rf) Ri is return on a security Rf is risk free rate Rm is market return Bi is beta
CAPM decision rule
if CAPM is below expected return, asset is undervalued
3 factors for evaluating capital investments
All cash flows through project’s life
Time value of money - evaluate costs and returns in present dollars
Cost of capital (required rate of return) - incorporate risk into required rate of return
opportunity cost
future investment opportunity lost due to time scope of current investment
tax shield
interest expenses are paid before taxes are calculated
interest expenses reduce taxable income
incremental cash flows
cash flows in or out of firm that result from accepting a project
non-incremental cash flows
costs a firm would incur regardless of accepting a project
2 guidelines when considering cash flows
capital budgeting occurs in CEO office, to judge impact on entire company
decide what really are incremental cash flows
Incidental cash flows
indirect cash flows that should be included in the project evaluation
cannibalization
one product steals sales from another product in the company
may be an incidental cost
sunk costs
irretrievable costs ie research development, market analysis
should not affect decisions on the future
