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Capital Budgeting traits 5

Analysis of potential projects

Good Decision Criteria

All cash flows considered?

Net Present Value question

How much value is created from undertaking an investment?

net present value

the difference between the cost of an asset and the present value of future cash flows

Net Present Value steps 4

Step 1: Estimate the expected future cash flows.

Net Present Value def

Sum of the PVs of all cash flows

CF0 ,

Net Present Value Initial cost often is what and is an what

CFt/[(1+R)^t]

Net Present Value t=0 calculation

Net Present Value t=1 calculation

sum of all{CFt/[(1+R)^t]} - (CF0)

accept the project

If NPV is positive, what should you do concerning the project

NPV > 0 means whatt 2

Project is expected to add value to the firm,

NPV is a direct measure of what

how well a project will meet the goal of increasing shareholder wealth.

Yes

Can test scores be reliable but not valid?

NPV Method

what is the the Dominant Capital Budgeting method

Payback Period def

How long it takes to recover the initial cost of a project

payback period

the time required for the money saved and/or the income generated by a project or product to equal its initial investment cost; determined as part of life-cycle cost analysis

steps 2

Estimate the cash flows

break-even

what type of measure is Payback Period

Payback Period Decision Rule

Accept if the payback period is less than some presnet limit

Payback Period method Disadvantages 5

Ignores the time value of money

Average Accounting Return calculation

Avg net income/avg book value

Average Accounting Return def

Avg net income/avg book value

a target cutoff rate

Average Accounting Return Requires what

Average Accounting Return Decision Rule

Accept the project if the AAR is greater than target rate.

Average Accounting Return

AAR stands for what

AAR Advantages 2

Easy to calculate,

Internal Rate of Return

Most important alternative to NPV

the estimated cash flows

Internal Rate of Return Based entirely on what

interest rates

Internal Rate of Return is Independent of what

IRR stands for what

Internal Rate of Return

Internal Rate of Return def

discount rate that makes the NPV = 0

Internal Rate of Return Decision Rule

Accept the project if the IRR is greater than the required return

IRR calculation steps 3

Enter the cash flows as for NPV

Preferred by executives

IRR - Advantages 5

IRR - Disadvantages 3

Can produce multiple answers

Intuitively appealing,

why is IRR Preferred by executives 2

Non-conventional cash flows,

When NVP and IRR won't give the same answer 2

def

Cash flow sign changes more than once

Non-conventional cash flows

Cash flow sign changes more than once

Initial cost (negative CF)

Most common IRR Non-Conventional Cash Flow 3

more than one

IRR Non-Conventional Cash Flows results in how many IRRs

the root of an equation

When you solve for IRR you are solving for what

1

for IRR, how many real roots are there per sign change, and the rest are what

Independent Exclusive Projects

The cash flows of one project are unaffected by the acceptance of the other.

mutually exclusive projects

Projects that, if undertaken, would serve the same purpose. Thus, accepting one will necessarily mean rejecting the others.

IRR

a % rate that equates the present value of the future benefits to the present value of the capital outlays by ownership; measure of investment performance frequently used for acquisition purposes

NPV assumes reinvestment at what

the firm's weighted average cost of capital

opportunity cost of capital,

the firm's weighted average cost of capital

NPV

what should be used to choose between mutually exclusive projects

Size (scale) differences,

Two Reasons NPV Profiles Cross

why do Size (scale) differences cause profiles cross 2

Smaller project frees up funds sooner for investment.

why do Timing differences cause profiles cross 2

Project with faster payback provides more CF in early years for reinvestment.

NPV directly measures the what 2

increase in value to the firm

Discounting Approach

Discount future outflows to present and add to CF0

Reinvestment Approach

Compound all CFs except the first one forward to end

Combination Approach

Discount outflows to present; compound inflows to end

different

will MIRR be the same or different number for each method

externally

MIRR Discount (finance) /compound (reinvestment) rate what supplied

Discounting Approach steps

Step 1: Discount future outflows (negative cash flows) to present and add to CF0

Reinvestment Approach steps 3

Step 1: Compound ALL cash flows (except CF0) to end of project's life

Combination Approach steps 3

Step 1: Discount all outflows (except CF0) to

Opportunity Cost

the value of the best alternative foregone; crucial in world of scarce resources

the multiple

MIRR avoids what IRR problem

Profitability Index

Measures the benefit per unit cost, based on the time value of money

A profitability index of 1.1 implies what

that for every $1 of investment, we create an additional $0.10 in value

capital rationing

Profitability Index Can be very useful in situations of what

Profitability Index Decision Rule

If PI > 1.0- Accept

Considers all CFs

how is Profitability Index Closely related to NPV, generally leading to identical decisions 2

Profitability Index Disadvantage

May lead to incorrect decisions in comparisons of mutually exclusive investments (can conflict with NPV)

Payback

is a commonly used secondary investment criteria

secondary investment criteria

Payback is a commonly used what

what does NPV measure

$ increase in VF

Liquidity (Years)

what does Payback measure

what does AAR measure

Acct return (ROA) %

E(R), risk %

what does IRR measure

If rationed Ratio

what does PI measure

NPV Rule

What the managers use, their goal is to maximize NPV

reasons to use NPV

discounts cash flows and therefore determines whether a project Will benefit stockholders

value additivity

The value of a firm is the sum of the values of the different projects, divisions or other entities within the firm.

payback period method

decides whether to accept or reject a project based on how quickly the initial investment is recovered

arbitrary standards

problems with the payback period method

discounted payback period method

decides whether to accept or reject a project based on how quickly the initial investment is recovered by discounted future cash flows

IRR method

determines a singular number to represent the intrinsic rate of return for the project; the IRR is the rate that causes the NPV to be zero

basic IRR rule

Accept the project if the IRR rate is higher than the discount rate. Reject if it is lower.

independent project

a project whose acceptance or rejection is independent of the acceptance or rejection of other projects

mutually exclusive investments

projects where acceptance of one is dependent on the rejection of the other

problems with IRR

does not take into account financing activities vs investing activities (the rule is opposite when the inflows happen First)

modified IRR

resolves problems with multiple rates of return by consolidating cash flows by discounting them