Week 5 - Topic 4 - Capital budgeting Flashcards
What does ‘risk’ refer to in the context of finance and investment?
the uncertainty of cash flows, in terms of the timing & magnitude of cash flow.
What is the risk for asset holders?
uncertainty in earnings (cash inflow)
What is the risk for liability holders?
uncertainty in cost (cash outflow)
Fill in the following one-word gaps: Greater volatility –> _____ risk, while lower volatility –> ______ risk
greater, lower
Define ‘Credit worthiness’?
how worthy you are of credit, how able you are to pay your debts.
Fill in the following one-word gap: Higher credit worthiness means ______ credit risk
lower
Define ‘Capital budgeting’?
is the process by which organisations determine whether their long-term investments, such as new machinery, replacement machinery, new plant, new products, and research development projects, are worth pursuing.
What is the objective of Capital Budgeting?
select investments in assets that will increase the value of the company, and maximise shareholders’ wealth.
What are the 5 things about capital budgeting that apply to assets and involve?
- Estimating CFs (inflows & outflows) through a timeline.
- Assessing the riskiness of CFs.
- Determining an appropriate discount rate (typically WACC)
- Finding NPV and IRR.
- Acceptance of project if NPV > 0 and/or IRR > discount rate (typically WACC).
Define Net Present Value (NPV)?
The dollar value added by the project.
Define Internal Rate of Return (IRR)?
the Expected Return E(R) of the project
Fill in the following one-word gaps: ______ NPV implies that the cost > worth. _____ invest.
Negative, Don’t
Fill in the following one-word gaps: ______ NPV implies that the cost > worth. _____ invest.
Positive, Do
What does 0 Net Present Value (NPV) imply?
implies that cost = worth
Define ‘Payback period’?
The number of years it takes for the cash flows from a project to recover the project’s initial investment.
Define ‘Conventional cash flow’?
one with an initial cash outflow followed by one or more future cash inflows.
