Uses of capital

Question 1

Assumptions of capital allocation:

Answer 1

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

Question 2

Decision rule for NPV

- independent projects and mutually exclusive projects

Answer 2

Independent:

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

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

Question 3

NPV is:

Answer 3

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

Question 4

IRR is:

Answer 4

• 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

Question 5

Decision rule for IRR

independent projects and mutually exclusive projects

Answer 5

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)

Question 6

If NPV and IRR conflicts occur:

Answer 6

• 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

Question 7

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

Answer 7

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

Question 8

Profitability index formula

Answer 8

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

Question 9

Payback period

Answer 9

• 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)

Question 10

Discounted payback period

Answer 10

• 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