Week 3 - Capital budgeting Flashcards
What are the key questions for capital budgeting?
What is cost of capital?
- the minimum risk-adjusted return that a project (investment) must earn in order to be acceptable to the shareholders
What are to two types of projects?
What are the two types of Cash Flows?
What are the different evaluation techniques?
What is the Payback Period?
- the number of years needed to recover the initial cost of investment
- Its a type of break even assesment
Pros and cons for The payback Period?
What is the discounted payback period?
Same as payback period, but cash flows are discounted. (Essentially offsetting the time that the project has paid back)
What is NPV?
- when should you accept (reject) the project?
- Sum of the PV of the CF, minus initial outlay/cost
- NPV>0 –> accept
What is the profitability index?
Sum of the present value of the CF divided by the initial costs
- so instead of subtracting (as with the NPV), we divide by the costs
–> Essentially the same as NPV
What is the IRR?
- IRR is the return on a firm’s invested capital over a period of time (n)
- IRR is the discount rate that equates the PV of CF to the initial cost –> Alternatively, set NPV = 0.
When should a firm accept (reject) a project according to IRR?
- IRR > k –> Accept
(k is the required rate of return - in other words ‘the cost of capital’).
NPV vs. IRR?
Explain
Strongest argument for choosing NPV over IRR?
What is the difference between Modified IRR and IRR?
MIRR assumes that CF are reinvested at the cost of capital (k) instead of at IRR
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When do we get multiple IRR?
and what is the relationship?
- if the project has more than one sign change, then we get multiple IRR
- for every change there is one IRR
