Capital Budgeting

According to Graham and Harvey's 2001 survey of 392 CFOs, which of the following capital budgeting methods are used by less than 50% of firms in the U.S. and Canada?

Profitability index (11.9%) Accounting rate of return (20.3%) Discounted payback (29.5%)

Internal Rate of Return (IRR)

Provides a single number (that does not depend on the various interest rates) summarizing the merits of a project. The number is internal or intrinsic to the project and does not depend on anything except the cash flows of the project. It is the most important alternative to the NPV method.

The discount rate is determined by the ______ of a project.

risk

What does value additivity mean for a firm?

(1) the value of a firm is simply the combined value of the firm's projects, divisions, and entities owned by the firm (2) the NPV values of individual projects can be added together.

Which of the following are true for a project with a negative initial cash flow followed by positive cash flows?

Accept if NPV is greater than zero. Reject if IRR is less than market rate of financing.

Basic IRR Rule

Accept the project if the IRR is greater than the discount rate. Reject the project if the IRR is less than the discount rate. (coincides exactly with the NPV rule)

True or false: Firms that are better able to estimate cash flows are less likely to use NPV.

False

According to Graham and Harvey's 2001 survey of 392 CFOs, which of the following two capital budgeting methods are most used by firms in the U.S. and Canada?

Net present value (74.9%) Internal rate of return (75.6%)

Which of these are weaknesses of the AAR method of project analysis?

No account of timing Arbitrary target rate Use of accounting values rather than cash flows

The payback period rule ______ a project if it has a payback period that is less than or equal to a particular cutoff date.

accepts

Because there is no guide for choosing the payback cutoff date under the payback method, the payback cutoff date is

arbitrary

Average accounting return (AAR) method

average project earnings after taxes and depreciation, divided by the average book value of the investment during its life. It is flawed by still sometimes used in the real world.

According to the basic investment rule for NPV, a firm should ______.

be indifferent towards accepting a project if NPV is equal to zero reject a project if NPV is less than zero. accept a project if the NPV is greater than zero.

Accepting a positive NPV project will ______ the stockholders by ______ the value of the firm.

benefit; increasing

Two mutually exclusive projects can be correctly evaluated by ______.

comparing the incremental IRR to the discount rate comparing the NPVs of the two projects examining the NPV of the incremental cash flows

We can evaluate two mutually exclusive projects by comparing the incremental IRR to the ______

discount rate

Which capital budgeting decision method finds the present value of each cash flow before calculating a payback period?

discounted payback period

The ____ discounts cash flows and then determines the time it takes for those cash flows to equal the initial investment.

discounted payback period method

NPV ______ cash flows properly.

discounts

AAR flaws

does not work with the raw materials. takes no account of timing

You must know the discount rate to make a decision under

either NPV or IRR

The movie industry frowns upon NPV analysis because their cash flows are ______ to predict.

hard

The timing of cash flows within the payback period

impacts the NPV of the project. is not considered by the payback method.

A dollar received one year from today has ______ value than a dollar received today.

less because today's dollar can be invested, yielding a greater amount in the future.

modified IRR (MIRR)

modify the cash flows first and then calculate IRR using the modified cash flows. It is unclear how to interpret MIRR. There are three methods to calculating MIRR. MIRRs don't suffer from multiple rate of return problem that IRRs do.

The difference between the sum of the present values of a project's future cash flows and the initial cost of the project is the project's

net present value (NPV)

As long as the cash flows are positive, the discounted payback period will ______ the payback period because discounting reduces the value of the cash flows.

never be smaller than

The discount rate assigned to a project reflects the ______

opportunity cost to the investor and risk of the project.

The ______ method differs from NPV because it evaluates a project by examining the time needed to recoup the initial investment.

payback

The ______ method is ideal for companies with limited funds that have a need for a quick turn-around of their capital.

payback

In general, NPV is

positive for discount rates below the IRR

In capital budgeting, the net ______ is the value of a project to the company.

present value

The numerator in the profitability ratio is the

present value of the future expected cash flows after the initial investment.

The spreadsheet function for calculating net present value is ______.

=NPV( )

Capital ______ is the decision-making process for accepting and rejecting projects.

Budgeting

The capital budgeting method that allows lower management to make smaller, everyday financial decisions easily is

the payback method

______ ________ implies that the NPV of a project is that project's contribution to a firm's value.

value additivity

The IRR is the discount rate that makes the NPV of a project equal to

zero

How to compare mutually exclusive projects

1. Compare the NPVs of the two choices 2. Calculate the incremental NPV from making the large-budget picture instead of the small-budget picture 3. compare the incremental IRR to the discount rate

Steps for calculating the discounted payback period.

1. Discount the cash flows using the discount rate. 2. Add the discounted cash flows 3. Accept if the discounted payback period is less than some pre-specified number of years

How do we use the profitability index?

1. Independent projects. PI > 1 whenever NPV is positive. Accept if PI >1. Reject if PI<1 2. Mutually exclusive projects. Ignores differences of scale for mutually exclusive projects and can be corrected using incremental analysis.

Three attributes of NPV

1. NPV uses cash flows. 2. NPV uses all the cash flows for the project 3. NPV discounts the cash flows properly.

Problems with payback

1. it does not consider the timing of the cash flows within the payback period. 2. It ignores all cash flows occurring after the payback period. 3. arbitrary standard for payback period. (The cutoff date is arbitrary)

You must know the discount rate to compute ______, while the discount rate is necessary to apply ______.

NPV, IRR

A firm has two mutually exclusive projects to choose from. Project A has an IRR of 40% and an NPV of $1,000. Project B has an IRR of 12% and an NPV of $25,000. Which of the following are true regarding the internal rate of return method?

IRR would have you choose Project A because the IRR is higher than Project B. IRR ignores issues of scale.

Why do companies choose to use IRR?

It summarizes information about a project in a single rate of return. It provides a simple way of discussing projects.

The discounted payback period has which of these weaknesses?

Loss of simplicity as compared to the payback method Exclusion of some cash flows Arbitrary cutoff date

If a firm accepts a project, the value of the firm will rise by the ______ of the project.

NPV

A project with a cash inflow of $250 followed by a cash outflow of -$300 one year later will have an IRR of _____ percent.

Reason: IRR is the interest rate that makes the NPV = 0: 0 = +$250 - $300/(1+IRR) Solving for IRR: → IRR = ($300/$250)- 1 = 20%

When would the payback method be useful for a company

The payback method is often used by large, sophisticated companies when making relatively small decisions. firms with good investment opportunities but no available cash may justifiably use payback companies with limited capital

Advantages of the payback period method for management

The payback period method is easy to use. The payback period method is ideal for minor projects. It allows lower level managers to make small decisions effectively.

True or false: The problem with IRR is that it ignores issues of scale.

True

True or false: Two challenges with the IRR approach when comparing two mutually exclusive projects are scale and cash flow timing.

True. If either of these issues are present, IRR may disagree with NPV over which project should be chosen.

The internal rate of return is a function of

a project's cash flows

The IRR allows a manager to summarize the information about a _____ project in a rate of return.

single

When using the spreadsheet function NPV, the cash outflow at Time 0 must be _____

subtracted from the PV of the other cash flows

The payback method ignores all cash flows occurring after the payback period which means

that some valuable long-term projects are likely to be rejected.

Using accounting numbers in the AAR method is a weakness because

the basic inputs are affected by the accountant's judgment. accounting numbers are somewhat arbitrary.