Week 4-capital budgeting part 1

Question 1

What are the 3 types of financial decisions?

Answer 1

1) investment-capital budgeting
What long term investments will you make?

2)Financing- capital structure
Where will you get long-term financing for your long term projects?

3)liquidity-working capital
How will you manage your everyday activities?

Question 2

What are the investment decision’s criteria?

Answer 2

• 2.1 Net Present Value
• 2.2 The Internal Rate of Return
• 2.3 The Payback Rule
• 2.4 The Average Accounting Return (optional)
• 2.5 The Profitability Index (optional)

Question 3

Describe the nature of project analysis

Answer 3

• The analysis and decision on whether to undertake a particular project is called capital budgeting or investment appraisal

• It involves using the discounted cash flow analysis to make decisions such as:
– Whether to enter a new line of business
– Whether to start producing a new product
– Whether to invest in equipment to reduce costs

• Individual projects are the unit of analysis

Question 4

What is the objective of firm?

Answer 4

• The objective of a firm, in mainstream finance theory, is the maximisation of the market value of shareholders’ equity (assuming this objective does not conflict with other social goals)

Question 5

State the procedural outline of project analysis

Answer 5

1. Form ideas on how to implement strategies of the firm and increase shareholders’ wealth
2. Plan how to implement the ideas
3. Gather information on timing and magnitude of costs and benefits. Estimate cash flows.
4. Apply decision criterion (rule)

Question 6

What is net present value?

Answer 6

• A project’s net present value is the difference between an investment’s market value and its cost all valued at the present time, i. e. the difference between the present value of all future cash inflows and all future cash outflows.
• It is the decision rule that ensure that the firm’s objective of maximising the shareholders’ current wealth is satisfied

Question 7

What is discounted cash flow valuation? (DFC)

Answer 7

The process of valuing an investment

by discounting its future cash flows.

Question 8

What is the NPV investment rule?

Answer 8

Accept: NPV is greater than zero
Reject: NPV is less than zero
Break-even point: indifferent when NPV=0

Question 9

What is the discount rate for NPV calculation?

Answer 9

• Discount rate used is called opportunity cost of capital (or market capitalisation rate)
• In other words, we are requiring the investment project to produce the potential rate of return we could earn by investing in other projects or securities with similar risk

Question 10

What are the strengths of NPV?

Answer 10

Uses all Cash Flows
• Other approaches ignore cash
flows beyond a certain date

Discounts Cash Flows
• Fully incorporates the Time
Value of Money

Represents the
additional value to
shareholders

Question 11

IRR, decision rule

Answer 11

First, I need to decide what is my opportunity
cost of capital, my required rate of return,
given the riskiness of the project.

• Calculate discount rate for which NPV = 0
• Compare IRR to required discount rate, the opportunity cost of capital
• ACCEPT project if IRR > opportunity cost of capital
• REJECT project if IRR < opportunity cost of capital

Question 12

What are the problems with IRR?

Answer 12

-Nonconventional Cash Flows can lead to multiple rates of return
The possibility that more than one discount rate
makes the NPV of an investment zero.

Mutually Exclusive Investments
A situation in which undertaking one
investment prevents the undertaking of
another.

A. There could be as many IRR in a project as there are changes in the signs of cash flows (Descartes rule)
B. It does not take into account the timing of each cash flow (because sum of discounted cash flows “forced” to add up to zero)
C. It is misleading when evaluating projects that are
mutually exclusive
D. It does not take into account the scale of the project

Question 13

How manz IRRs?

Answer 13

The maximum number of IRRs that there can be is equal to the number of times that the cash flows change sign from positive to negative and/or negative to positive

Question 14

What is the pazback rule?

Answer 14

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.

Payback period is the project life resulting in NPV = 0.

Question 15

What is the payback period method?

Answer 15

Accept: • Payback Period is less than
benchmark

Reject: • Payback Period is greater
than benchmark