Uses of capital Flashcards

1
Q

Assumptions of capital allocation:

A
  1. decisions are based on CF
    - use incremental CF
    - exclude sunk costs
    - include externalities
    - conventional v unconventional CFs
  2. CF are not accounting net income or operating income
  3. CF are based on opportunity cost
  4. CF are analyzed on an after-tax basis
  5. timing of CF is vital
  6. financial costs are ignored
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2
Q

Decision rule for NPV

- independent projects and mutually exclusive projects

A

Independent:

  • If NPV > 0, accept
  • If NPV < 0, reject

Mutually exclusive projects:
- accept the project with the higher and most positive NPV

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3
Q

NPV is:

A
  • the present value of future after tax CF minus the investment outlay
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4
Q

IRR is:

A
  • the discount rate that makes the PV of future CFs equal to the investment outlay
  • or, IRR is the discount rate which makes NPV equal to 0
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5
Q

Decision rule for IRR

independent projects and mutually exclusive projects

A

Independent projects

  • If IRR > required rate of return (hurdle rate, cost of capital), accept the project
  • If IRR < required rate of return, reject the project

Mutually exclusive projects
- accept the project with the higher IRR (as long as IRR > cost of capital)

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6
Q

If NPV and IRR conflicts occur:

A
  • for single/independent projects with conventional CF, there will be no conflict between NPV and IRR
  • for mutually exclusive projects, the two criteria may give conflicting results due to differences in CF patterns and differences in project scale
    • if there is a decision conflict, ALWAYS GO WITH NPV

choose NPV because:

  • NPV is a direct measure of expected increase in value
  • NPV assumes reinvestment of cash at the required rate of return (more realistic); IRR assumes reinvestment of CF at the IRR rate (less realistic)
  • IRR is not useful for projects with non-conventional CF
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7
Q

Nominal CF should be discounted at a _____ discount rate, and real CF should be discounted at a _______ rate

A

discount nominal cf at a nominal discount rate and discount real cf at a real rate.

  • nominal CF includes the effects of inflation
  • real CFs are adjusted downward to remove the effect of inflation

(1+nominal rate) = (1 + real rate) + (1 + inflation rate)

inflation reduces the value of depreciation tax savings
Higher-than-expected inflation increases the firm’s real taxes and shifts wealth from the firm to the govt
Inflation does not affect all revenues and costs uniformly

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8
Q

Profitability index formula

A

PI = (PV of future CFs) / initial investment

or, NPV + initial investment / initial investment

Higher PI is better

PI > 1 good
PI < 1 bad
PI = 0 breakeven

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9
Q

Payback period

A
  • is the number of years required to recover the original investment in a project
    Use cumulative net cf for each per
    ie. -500 outflow initial cost
    yr1 +150
    yr2 +250
    yr3 +400
    yr 4 +600
    the payback per is between yr 2 and 3; use interpolation to solve
    on fin cal: plug in numbers under CF, the NPV and arrow down to “PB”, click cpt = 2.25

Pros
- a good measure of a project’s liquidity and useful to firms with liquidity concerns
Cons
- poor measure of project’s profitability ( does not take into account cf beyond the payback per; so terminal value or terminal value are not considered)
- does not take into account TVM (use the discounted payback per for this)

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10
Q

Discounted payback period

A
  • discounts future CF back to current yr
  • use the same steps on fin cal as with payback per, input I, CPT “DPB” = 2.377 years

the discounted PB 2.377 years is longer than the regular PB of 2.25 years
the discounted PB will always be longer

  • still does not consider profitability
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