Finance Test #2 chapter 8
Payback Period
Amount of time a project requires to pay back the initial equity investment
investment analysis tools
Net present value, Internal rate of return, modified internal rate of return (lenders use these to make investment decisions)
Net Present Value
The present value of an asset less its initial cost. calculates the difference between an asset's present value and purchase price
Advantage of payback period
easy to calculate
Factors impacted investment analysis
Cost of capital (WACC), cap rate used to calculate the assumed sale price at the end of the analysis period, amount and timing of annual cash flows projected
Disadvantage of Net Present Value
Difficult to compare multiple investment opportunities with different costs
Modified internal rate of return (MIRR)
Rate of return which assumes all cash flows are reinvested at the firms WACC, MIRR is more conservative than IRR
IRR disadvantages
Assumes cash flows generated by the project are reinvested at the IRR calculated, multiple IRR's when cash flows go from negative to positive.
Cap Rate Method Equation
CR (X) = CF or X=CF/CR x=estimated current market value CR= cap rate (WAAC) CF= prior or trailing 12 months of cash flow
Discount Rate
Includes the cost of debt and investors required ROI, used to calculate present value of an asset by discounting each year's cash flow
Payback period calculation
Payback period= cost divided by incremental cash flow
Advantages of Net present value
Takes into account all cash flows, takes into consideration the TVM
What does a discount rate mean?
The discount rate represents the required rate of return to make a business acquisition worth while. The idea is to look at a business purchase as an investment decision. Given that point of view, the business investment must be compared against other, possibly safer, alternatives.
Internal rate of Return
The discount rate that makes the present value of a cash flowing asset equal to its acquisition price or project cost. * want the IRR to make the net present value of an investment equal to zero
Capitalization Method of Valuation
Used to estimate the current market value of a cash flowing asset by dividing the amount of the prior 12 months cash flow by the rate. Cap rate is the investor's short term WACC *as the cap rate increases, the market value decreases.
Components of investment analysis
Weighed average cost of capital, discount rate, capitalization method of valuation
WACC
amount of interest expense and cash flow allotted to equity investors divided by the amount of capital, Takes into consideration - capital mix and tax effect (interest portion of debt service treated as an expense for tax purposes in the US)
IRR advantage
compare multiple deals with varying sales prices and costs
Disadvantages of payback period
does not include the time value of money, ignores cash flow after the required payback period
Terminal selling price
the estimate price for which the asset could be sold at the end of the analysis period when calculating present value of a potential investment, terminal selling price is an important component of investment value
acquisition price
the lower the price of the asset or total project cost, the higher the NPV and IRR
Amount of timing projected cash flows
the more cash flow projected in the early years, the higher the PV, NPV and IRR
Cost of capital
the more financial leverage used, the lower the cost of capital, the lower the cost of capital, the lower the discount rate the lower the discount rate the higher the present value and NPV
Weighted average cost of capital (WACC)
used to calculate present value of an investment, rate used to discount future cash flows, mix of debt and equity depends on how much the company can borrow and pay debt service
Cap rate
used to estimate the current market value of a cash flowing asset by dividing the amount of the prior 12 months cash flow by the rate. Cap rate is the investor's short term WACC, the lower the cap rate the higher the sales the higher the cap rate, the lower the PV, NPV and IRR
