Finance Unit 10

The payback period can lead to foolish decisions if it is used too literally because

it ignores cash flows after the cutoff date

Occurs when funds are not available and managers must choose the 'best' projects from among all available projects

Hard Rationing

____________ gives the rate of return earned on a project, which can then be compared to the opportunity cost to determine whether the project should be adopted.

Internal Rate of Return (IRR)

_______ is a measure of how much value is created or added by undertaking an investment

Net Present Value

_____ measures the wealth increase of a project

Net Present Value (NPV)

Which of the following are methods of calculating the MIRR of a project - the discounting approach - the reinvestment approach - the present value approach - the combination approach

- The discounting approach - The reinvestment Approach - The combination approach

Occurs when limits on investments are made by a firm's managers for better control of the firm.

Soft Rationing

Which step in the capital budgeting process is the most importants

Step 3 = evaluating investments

The internal rate of return is a function of ____

a project's cash flow

A(n) __________ of the payback period rules is that it is easy to understand

advantage

one of the weakness of the payback period is that the cutoff date is a(n) ________ standard

arbitrary

Projects can be _______, meaning a company can take a portion of a project

divisible

Pay back and Account Rate of Return are called traditional in that they _______

do not use the elements of economic value

Investments may _____, _____, ______ or __________

expand revenue reduce costs renew major assets be required by government regulation

Projects can also be ________, where managers must take all or nothing.

indivisible

The ranking decision with capital rationing is not due to the nature of the projects, but due to

limits on available investment capital

The _____ method evaluates a project by determining the time needed to recoup the initial investment

payback

The ____ is best suited for decisions on relatively small, minor projects while _____ is more appropriate for large complex projects

payback period NPV

The ranking decision with mutually exclusive projects was caused by

the nature of the projects themselves

What are the 6 steps/phases of the capital budgeting process?

1. Develop Long-Term Goals 2. Screen Investments 3. Evaluate Investments 4. Implement the Project 5. Control 6. Audit

What is the two-step process involved with step 3 of the capital budgeting process?

3. Evaluate investments 1. Estimate the cash flows involved 2. Evaluate cash flows using a chosen evaluation method

The spreadsheet function for calculating net present value ie _____

=NPV(rate, CF1,....,CFn) +CF0

ARR =

Average net income / average book value

Which of the following is a disadvantage of the Profitability Index? - Easy to understand - useful when capital is rationed - is closely relation to NPV - Cannot rank mutually exclusive projects

Cannot rank mutually exclusive projects

Payback period =

Cost of project /annual cash inflow

_________ projects include ones when making one choice is independent of other choices. Capital budgeting for these projects involves an accept/reject decision.

Economically independent

Why would the payback period be used in making financial decisions?

If a company has limited capital they will use the payback period (from a group of projects that have a positive NPV) to determine which ones will have the most cash inflows in the future.

Why are there so many rules for capital budgeting decisions?

because firms have different objectives. The only universal rule is to not investment i a project unless it ahs a positive net present value

Purchasing a car is an example of a _______ expenditure

capital

Which of the following present problems when using the IRR method? - Larger cash flows later in the project - mutually exclusive projects - a high discount rate - non-conventional cash flows

- non-conventional cash flows - mutually exclusive projects

If a project has multiple internal rates of return, which of the following methods should be used? -NPV -IRR -MIRR

- NPV -MIRR

What is the IRR for a project with an initial investment of $500 and a subsequent cash inflows of $145 per year for 5 years

13.82%

Suppose the NPV for a project's cash flows is computed to be $2,500. What does this number represent with respect to the firm's shareholders?

A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted. This does not mean the shareholders get a check for that amount: it is a statement of the expected increase in wealth given the project

What are some of the difficulties that might come up in actual applications of the various criteria we discussed in this course. Which one would be the easiest to implement in actual applications? The most difficult?

Coming up with reliable cash flow estimates is a big difficulty. companies operate in a market environment a thus subject to changes due to fiscal policies, regulations, technology, competition etc. Determining an appropriate discount rate is hard bc its subject to inflationary pressures and goverments have active monetary and exchange-rate policies that affects interest rates The most dangerous difficulties would occur if managers did not use proper time value decision rules.

What is the audit phase of the capital budgeting process really asking?

How can the capital budgeting process be refined?

Diamond Enterprises is considering a project that will produce cash inflows of $41,650 a year for three years followed by $49,000 in Year 4. What is the internal rate of return if the initial cost of the project is $142,000?

IRR = 8.42% NPV = 0 = -$142,000 + $41,650 / (1 + IRR) + $41,650 / (1 + IRR)2 + $41,650 / (1 + IRR)3 + $49,000 / (1 + IRR)4

Molly is considering a project with cash inflows of $811, $924, $638, and $510 over the next four years, respectively. The relevant discount rate is 11.2 percent. What is the net present value of this project if it the start-up cost is $2,700?

NPV = -$2,700 + $811 / 1.112 + $924 / 1.1122 + $638 / 1.1123 + $510 / 1.1124 NPV = -$425.91

Professional Properties is considering remodeling the office building it leases to Heartland Insurance. The remodeling costs are estimated at $2.8 million. If the building is remodeled, Heartland Insurance has agreed to pay an additional $820,000 a year in rent for the next five years. The discount rate is 12.5 percent. What is the benefit of the remodeling project to Professional Properties?

NPV = -$2,800,000 + $820,000 ×{1 - [1 / (1 + .125)5]} / .125 NPV = $119,666.04

The Management of Premium Manufacturing Company is evaluating two forklift systems to use in its plant that produces the towers for a windmill power farm. The costs and the cash flows from these systems are shown below. If the company uses a 12 percent discount rate for all projects, determine which forklift system should be purchased using the net present value (NPV) approach.

Otis Forklifts

T/F - NPV guides managerial decisions

TRUE

What is the profitability index decision rule?

The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one. A PI greater than one indicates that the project will return more than a dollar for each dollar invested, with this comparison using proper time value analysis

Describe how the profitability index is calculated and describe the information this measure provides about a sequence of cash flows.

The profitability index is the present value of the future cash flows, discounted by the opportunity cost, divided by the initial investment. It measures the wealth created per dollar invested, providing a measure of the relative profitability of a project.

When hard rationing occurs, companies may find the following:

They may not have sufficiently retained earnings to finance all profitable projects. They may not be able to secure additional bank financing. They might find the capital markets are not receptive to additional security issues.

Screen Investments is really asking

What is the nature of the investment

What is the control phase of the capital budgeting process really asking?

What will change? regarding the economic environment

What is the relationship between the profitability index and the NPV? Are there any situations in which you might prefer one method over the other? Explain.

Whereas NPV measures the total wealth creation of a project, PI gives the wealth creation per dollar invested if a firm has a basket of positive NPV projects and is subject to capital rationing, PI may provide a good ranking measure of the projects, indicating the "bang for the buck" of each particular project..

According to the average accounting return rule, a project is acceptable if its average return exceeds

a target average acocunting return

Higher cash flows earlier in a projects life are _____ valueable than higher cash flows later on

more - present value is inversely related to time. Cash flows earlier in the project life are more valueable as they can be reinvested

The possibility that more than one discount rate can cause the net present value of an investment to equal zero is referred to as:

multiple rates of return

If a firm is evaluating two possible projects, both of which require the use of the same production facilities, these projects would be considered

mutually exclusive

____ focuses on liquidity. It measures the time necessary for a project to return its initial investment.

Payback

What are the special capital budgeting situations?

1. Economically independent projects 2. Mutually exclusive projects 3. capital rationing

Three major capital budgeting decision rules

1. Net present value (NPV) 2. Internal rate of return (IRR) 3. Profitability Index (PI)

Which of the following are reasons why IRR continues to be used in practice? - The IRR allows the correct ranking of projects. - Business people prefer to talk about rates of return - The IRR of a proposal can be caluculated without knowing the appropriate discount rate - It is easier to communicate information about a proposal with an IRR

1. The IRR of a proposal can be calculated without knowing the appropriae discount rate. 2. It is easier to communicate information about a proposal with an IRR. 3. Businesspeople prefer to talk about rates of return.

What is the profitability index for a project with an initial cash outflow of $30 and subsequent cash inflows of $80 in year one and $20 in year two if the discount rate is 12%?

=((80/1.12)+(20/1.12^2))/30=2.91

What is the NPV of a project with an initial investment of $95, a cash flow in one year of $107, and a discount rate of 6 percent?

NPV=-$95+(107/1.06)=$5.94

_______ uses the Average Accounting Net Income and Average Investment to determine a rate of return.

Account Rate of Return (ARR)

_________ uses the Average Accounting Net Income and Average Investment to determine a rate of return. If this rate of return exceeds the minimum rate required by managers, then the project is accepted.

Account Rate of Return (ARR)

____________ are major investments that are long-lived, expensive and difficult to unwind. Companies therefore use a formal decision process and economic evaluation tools for deciding on whether to obtain these.

Capital Assets

________ happens when there is not enough capital to take on all wealth-increasing projects.

Capital rationing

_______ focuses on liquidity. It measures the time necessary for a project to return its initial investment. The shorter the payback the more desirable the project.

Paback

T/F - an advantage of AAR is that it is based on book values, not market values

FALSE - disadvantage

T/F - Payback and account rate of return can tell managers how market values will be affected by their decisions

FALSE - they cannot tell the manager these things

T/F - paypack method and ARR properly use cash flow, time value of money and opportunity cost to make decisions

FALSE - they do NOT properly use

Why would the IRR rule be used to pick a project?

For conventional projects IRR will be used because its easier to understand and communicate.

What does implementing the project really ask?

How will the project begin?

According to Graham and Harvey's 1999 survey of 392 CFos, which of the following two capital budgeting methods are widely used by firms in teh US and Canada? - PI - Payabck - IRR - NPV - ARR

IRR NPV

Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV? Explain

IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms. IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR would provide more information about the project than would NPV.

What is the relationship between IRR and NPV? Are there any situations in which you might prefer one method over the other? Explain.

IRR is the interest rate that a project earns, whereas the required rate of return is the opportunity cost of the project: the rate of return the project should earn given its risk. NPV directly uses the opportunity cost to evaluate the project's cash flows, and is thus is preferred in all situations to IRR. For stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques; however, IRR can lead to ambiguous results if there are non-conventional cash flows, and also ambiguously ranks some mutually exclusive projects.

What is evaluating investments really ask you?

Is the investment economically desireable

Companies may want to do each of these during soft rationing:

Limit growth to a manageable level existing owners may not want to issue additional financial securities, which might dilute their control of the company

What is the role of managers in implementing the project?

Managers must translate the capital budgeting plan into action. Any weaknesses in the plan will be discovered once the project begins

______ projects occur when you are choosing from among alternatives and then pick only the best one. Capital budgeting for these projects involves a ranking process.

Mutually exlcusive

Why is NPV considered to be a superior method of evaluating the cash flows from a project?

NPV is superior to the other methods of analysis presented in our course because it directly measures a decision's impact on wealth The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria as well.

Describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule?

NPV is the sum of the present values of a project's cash flows. The NPV decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV.

Describe how the payback period is calculated and describe the information this measure provides about a sequence of cash flows. What is the payback criterion decision rule?

Payback period is simply the break-even point of a series of cash flows. To actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback.

What are the two issues phase 1 of the capital budgeting process must strategize through?

Phase 1 = Developing Long-Term Goals 1. Does the investment fit the company? 2. Is the investment economically profitable

______________ is a ratio of the present value of the inflows and outflows used in NPV analysis. It calculates the wealth created per dollar invested.

Profitability Index (PI)

T/F - Projects can contain both divisible and indivisible aspects, but for our course we will keep these aspects separate.

TRUE

T/F - Some projects, such as mines, have cash outflows followed by cash inflows and cash outflows again, giving the project multiple internal rates of return.

TRUE - whenever subsequent cash flows are both negative and postiive, multiple internal rates of return may occur

A formal decision-making process called _______ is used to guide capital expenditure decisions many companies make.

The Capital Budgeting Process

Describe how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. What is the IRR criterion decision rule?

The IRR is the rate of return earned on an investment. It is the discount rate that causes the NPV of a series of cash flows to be equal to zero at the IRR discount rate, the net value of the project is zero. The IRR decision rule is to accept projects with IRRs greater than the discount rate, and to reject projects with IRRs less than the discount rate.

b. What are the problems associated with using the payback period as a means of evaluating cash flows?

The worst problem associated with payback period is that it ignores the time value of money. In not using time value, it also does not use an opportunity cost which would reflect the uncertainty of the cash flows. Additionally, the selection of a hurdle point for payback period is an arbitrary exercise that lacks any steadfast rule or method. The payback period is biased towards short-term projects; it fully ignores any cash flows that occur after the cutoff point.

Are the capital budgeting criteria we discussed applicable to not-for-profit corporations? How should such entities make capital budgeting decisions? What about the U.S. Government? Should it evaluate spending proposals using these techniques?

Yes non-profits need capital budgeting. "revenues" from non-profits arent always tangible. They also have no stock price or market determined discount rate to use in their decisions. However, like for-profit corporations, cost-benefit analysis is important and must be done as effectively as possible given these limitations Yes the government should as well and they do put cost-benefit analysis into laws

a. Describe how the average accounting return is usually calculated and describe the information this measure provides about a sequence of cash flows. What is the AAR criterion decision rule?

a. The average accounting return is interpreted as an average measure of the accounting performance of a project over time, computed as some average profit measure due to the project divided by some average balance sheet value for the project. This text computes AAR as average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target measure, and reject all other projects.

The PI rule for an independent project is to ______ the project if the PI is greater than 1.

accept

A project should be _____ if its NPV is greater than zero

accepted

If the arr exceeds the minimum rate required by managers, then the project is ________

accepted

ARR =

average net income / average book value

The average accounting return is defined as:

average net income/average book value

b. What are the problems associated with using the AAR as a means of evaluating a project's cash flows? What underlying feature of AAR is most troubling to you from a financial perspective? Does the AAR have any redeeming qualities?

b. AAR is not a measure of cash flows and market value, but a measure of financial statement accounts that often bear little semblance to the relevant value of a project. In addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager, both the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money considerations are troubling. Despite these problems, AAR continues to be used in practice because (1) the accounting information is usually available, (2) analysts often use accounting ratios to analyze firm performance, and (3) managerial compensation is often tied to the attainment of certain target accounting ratio goals.

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

budgeting

What are the advantages of using the payback period to evaluate cash flows? Are there any circumstances under which using payback might be appropriate? Explain

c. Despite its shortcomings, payback is often used because the analysis is straightforward and simple. Materiality considerations often warrant a payback analysis as sufficient; maintenance projects are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important. It may also be used when opportunity cost would be difficult to estimate.

The net present value of an investment represents the difference between the investment's:

cost and its market value

Payback period =

cost of project / annual cash inflow

Buying a tank of gas is an example of a _____ expenditure

current

The net present value profile illustrates how the net present value of an investment is affected by which one of the following?

discount rate

The internal rate of return is the:

discount rate that results in a zero net present value for the project.

Net present value involves discounting an investment's:

future cash flows

The present value of the future cash inflows are divided by the ____ to calculate the profitability index

initial investment

According to the basic IRR rule, we should:

reject a project if the IRR is less than the required return

The ________ the payback the more desireable the project

shorter

The Irr is the discount rate that makes NPV equal to

zero