Chapter 11 FINC 341

What does "safety margin of profit" mean?

The difference between IRR and WACC. The bigger the difference between these numbers, the higher "the safety margin of profit".

What are the three primary methods that are used to evaluate projects?

NPV, IRR, and MIRR

____ ____ ____ ____ is a graph showing the relationship between a project's NPV and the firm's cost of capital.

Net Present Value Profile

IRR is the ___ of a project expressed completely in a ____ of ____, leaving none of the return to be expressed as NPV dollars (hence NPV = $0)

Return, Percentage, Return

What are the five capital budgeting evaluation techniques?

1.) Payback Period 2.) Discounted Payback Period 3.) Net Present Value 4.) Internal Rate of Return 5.) Modified Internal Rate of Return

SCE: You should only use ____ ____ and ___ _____ ____ to choose between two projects. These two methods are called "____ methods".

Payback Period, Discounted Payback Period, Secondary

What are the two weaknesses to using DPP?

1.) DPP does not necessarily use all cash flows 2.) Does not measure profitability

For NPV profiles, what are the two things that can cause crossovers?

1.) Different Sizes 2.) Reinvestment rate difference for NPV vs IRR

What are the three weaknesses to the Payback Period?

1.) Does not use TVM 2.) Does not necessarily use all cash flows 3.) Does not measure profits

Cash Flows expected in the distant future are generally riskier than near-term cash flows , so payback is used as one ____ indicator for projects.

Risk

For NPV profiles, what indicates that a crossover will occur?

1.) Negative Cash Flows 2.) Differences in cash flow patterns (Like how one project can have ascending cash flows and another might have descending cash flows)

What are the four strengths of MIRR?

1.) If project sizes are equal, MIRR will always agree with NPV as to which project is better 2.) Takes into account TVM 3.) Takes all Cash Flows into account 4.) Better indicator of a project's true rate of return than IRR

What are the two strengths of the Payback Period?

1.) It is easy to use/calculate 2.) It shows relative safety

What is the one weakness to NPV?

1.) NPV cannot be used to compare projects with different lengths of life

Rank the best Capital Budgeting Evaluation Techniques for mutually exclusive projects from best to worst.

1.) NPV, 2.)MIRR (or tied for 1st) 3.) IRR 4.) DPP 5.) PP

Rank the best Capital Budgeting Evaluation Techniques for independent projects from best to worst.

1.) NPV, IRR, MIRR 2.) DPP 3.) PP

As K increases, nothing will happen to the cash flow at t=__, however all other cash flows will be affected.

0

For NPV profiles, the Relevant range is between where K % equals ___ to ____%.

0, 30

What are the two basic conditions that cause NPV profiles to cross and thus lead to conflicts?

1.) Timing Differences. If most the cash flows from one project come in early while most the those from the other project come in later, the NPV profiles may cross and result in conflict. 2.) Project Size (or scale differences). If the amount invested in one project is larger than the amount invested in another project, this can lead to NPV profiles crossing and a resulting conflict.

What are the two weaknesses of IRR?

1.) Uses IRR as a reinvestment rate. (This is usually unrealistic) 2.) When mutually exclusive projects differ in sizes, you can't trust IRR to choose the project that adds the most value to a firm. (i.e. Maximize stock price)

What are the two strengths to using DPP?

1.) Uses TVM 2.) Shows Relative Safety

What are the three strengths of IRR?

1.) Uses TVM 2.) Uses all cash flows 3.) Measures Return

What are the five strengths of NPV?

1.) Uses the TVM 2.) Uses all Cash Flows 3.) Measures Profitability 4.) Uses a valid reinvestment rate for interim cash flows 5.) When mutually exclusive projects have different sizes, the NPV will choose the project that adds the most value to the firm

SCE: Facebook tanked today on 7/26 and their stock price fell by ____%. because Facebooked missed their expected earnings.

19

What is the rule for NPV?

A project is profitable if it's NPV is greater than zero.

If a projects IRR exceeds a project's WACC, ____ the project. If a projects IRR is less than the project's WACC, ___ it.

Accept, Reject

The shorter the payback period, the ____ the project.

Better

Note that payback is a "____-____" calculation in the sense that is cash flows come in at the expected rate, the project will break even. However, because the regular payback doesn't consider the cost of capital, it doesn't specify the true break-even year. The discounted payback does consider capital cost, but it still disregards cash flows beyond the payback year, which is a serious flaw.

Break Even

The ____ __ is the cost of capital at which the NPV profiles of two projects cross and thus, at which the project's NPV's are _____.

Crossover Rate, Equal

If you are choosing between two mutually exclusive projects, and neither project has a positive NPV, then both projects should be _____.

Rejected

___ ____ is the process of planning expenditures on assets with cash flows that are expected to extend beyond one year. AKA: ____ _____ is a summary of planned investments in long-term assets, and ______ ___ is the whole process of analyzing projects and deciding which ones to use in the capital budget.

Capital Budgeting, Capital Budget, Capital Budgeting

Note that at a zero cost of capital, the NPV is simply the net total of the undiscounted ____ flows. This value will be plotted on a Net Present Value Profile as the ____ axis intercept.

Cash, Vertical

If NPV and IRR don't agree with one another on which mutually exclusive project is more profitable, then their is a ____ on the NPV profile.

Crossover

For NPV profiles, The ____ ____ or ____ ___ is the rate that makes the NPV's of two profile lines equal. This rate makes the differences between the NPV's of two profile lines equal to ___.

Crossover Point, Crossover Rate, Zero

Discounted Payback Period is symbolized by?

DPP

When comparing two projects of the same size and time, if one project has more cash flows in the later years than another, then that project's profile line for the project with cash flows later in life will ____ at a much more ___ pace than the profile line for the project with most of it's cash flows occurring early in the project's life.

Decline, Rapid

Note: NPV _____ as K increases.

Decreases

The ___ ___ ____ is the length of time required for an investment's cash flows, discounted at the investment's cost of capital, to cover its cost. AKA: The ____ ____ ___ is the expected number of years required to recover a project's cost when all CFs are expressed in today's dollars.

Discounted Payback Period, Discounted Payback Period

SCE: _____ tanked today on 7/26 and missed their earnings. _____'s stock plunged ___%.

Facebook, Facebook, 19

We saw in Chapter 3 that their is a difference between cash flows and accounting income, and we noted that investors are particularly concerned with ____ ___ ___. Recall that ___ ___ __ represents the net amount of cash that is available for all investors after taking into account the necessary investments in fixed assets (capital expenditures) and net operating working capital.

Free Cash Flows, Free Cash Flows

If WACC or K is ____ than the crossover rate, then both NPV and IRR will agree that one project is better than another mutually exclusive project. However, if the cost of capital is _____ than the crossover rate, a disagreement will arise.

Greater, Less

Out of two projects, accept the project with the _____ IRR, provided that the IRR is greater than the WACC. Reject all projects if the best IRR does not exceed ____.

Higher, WACC

A project with all negative cash flows wont have an ____.

IRR

Another problem with IRR is that under certain conditions a project may have more than one ____.

IRR

If an independent project with normal cash flows is being evaluated, the NPV and ____ criteria will always lead to the same project accept/ reject decision.

IRR

Internal Rate of Return is symbolized by?

IRR

_____ is the average rate of return for a project per year.

IRR

How is IRR affected when the cost of capital changes?

IRR would not be affected if the k or WACC changes.

For NPV profiles, ____ is the rate that makes ____ equal to zero.

IRR, NPV

For big companies, ____ is better, for smaller companies, ____ is better.

IRR, NPV

The ___ is an estimate of a project's rate of return, and it is comparable to ___ on a bond.

IRR, YTM

____ is the discount rate which forces the PV of a project's inflows to equal the PV of it's outflows (i.e. NPV=____)

IRR, Zero

The crossover rate is found by calculating the ____ of the ______ in two project's cash flows.

IRR, differences

If Walmart was considering a new store in Boise and another in Atlanta, the projects would both be ______, and if both projects had positive NPVs, Walmart should _____ both. ____ _____ projects, on the other hand, are projects where if one project is accepted, the other project must be ____.

Independent, Accept, Mutually Exclusive, Rejected

_____ projects are projects with cash flows that are ____ affected by the acceptance or non-acceptance of other projects.

Independent, not

When using MIRR, the FV that you will put into your calculator to solve for MIRR will be the FV of all cash _____ all compounded to FV.

Inflows

When calculating for MIRR in your calculator, you are really solving for the ____ ____.

Interest Rate

Cash Flows that are not at the beginning or the end of a timeline are called ___ cash flows.

Interim

____ is simply the present value of a project's free cash flows discounted at the cost of capital. The ____ tells us how much a project contributes to shareholder wealth - the larger the ____, the more value the project adds; and added value means a higher stock _____.

NPV, NPV, NPV, Price

What is the biggest weakness of using the Payback Period?

It does not consider the TVM

What information does the payback convey that is absent from the other capital budgeting decision methods?

It tells you essentially when a project will break even.

A project is profitable if IRR is greater than ____.

K

For NPV profiles, MIRR will always be an IRR pulled towards ___.

K

For NPV profiles, the horizontal axis is equivalent to _____ ___.

K %

What are the 3 different things that WACC can be called?

K, Discount Rate, or Hurdle Rate

MIRR is usually between IRR and ___. However, it is more gravitating toward __ than IRR.

K, K

The shorter the payback, other things held constant, the greater a project's ____.

Liquidity

Modified Internal Rate of Return is symbolized by?

MIRR

The ____ is superior to the regular IRR as an indicator of a project's "true" rate of return.

MIRR

____ is the discount rate at which the present value of a project's cost is equal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows, compounded at the firm's cost of capital.

MIRR

If a project with normal cash flows does not have any interim cash flows, the project's ____ will equal the project's ____, whether the project is profitable or not.

MIRR, IRR

If the NPV for a project with normal cash flows is positive, then both the ____ and the ___ will be greater than the cost of capital.

MIRR, IRR

The single best capital budgeting decision criterion is _____ because it addresses the central goal of financial management- to maximize ___ wealth.

NPV, Shareholder

When using MIRR, whenever a negative cash flow gets discounted back to PV, the cash flow is still ____.

Negative

The MIRR has two significant advantages over the regular IRR. First, whereas the regular IRR assumes that the cash flows from each project are reinvested at the IRR, the MIRR assumes that the cash flows are reinvested at the cost of capital (or some other explicit rate). Because reinvestment at the IRR is generally not correct, the MIRR is generally a better indicator of a project's true profitability. Second, the MIRR eliminates the _____ IRR problem -- there can never be more than one MIRR, and it can be compared with the cost of capital when deciding to accept or reject projects.

Multiple

Whenever a project experiences non-normal cash flows, a project may have ____ IRRs.

Multiple

____ ___ is the situation where a project has two or more IRRs.

Multiple IRRs

ME stands for?

Mutually Exclusive

___ ___ Projects means that taking on project excludes you from taking on another project.

Mutually Exclusive

____ _____ projects are a set of projects where only one project can be accepted.

Mutually Exclusive

If you have projects of unequal sizes, then you cant trust anything but _____ to tell you what the most profitable project is.

NPV

Net Present Value is symbolized by?

NPV

For NPV profiles, The vertical axis is equivalent to _____ ____.

NPV Dollars

For independent projects, the ____, ____, and _____ always reach the same accept/reject conclusion, so the three criteria are equally good when evaluating independent projects. However, if projects are mutually exclusive and they differ in size, conflicts can arise . In such cases, the ____ is the best because it selects the project that maximizes value.

NPV, IRR, MIRR, NPV

A project is said to have ____ cash flows if it has one or more cash outflows (costs) followed by a series of cash inflows. If, however, a cash outflow occurs sometime after the inflows have commenced, meaning that the signs of the cash flows change more than once, a project is said to have _____ cash flows.

Normal, Non-normal

Normal Cash Flows only have ___ sign change, but non-normal cash flows have more than ____ sign change.

One, One

When using MIRR, the PV that you will put in your calculator to solve for MIRR will be the PV of all cash ___ (___) all discounted to the PV.

Outflows, Costs

It is logical for managers to want to know the expected rate of return on investments, and that is what the IRR is supposed to tell them. However, the IRR is based on the assumption that project's cash flows can be reinvested at the IRR. This assumption is generally incorrect, and this causes the IRR to _____ a project's true return.

Overstate

Payback Period is symbolized by?

PP

Size= ____

PV ( all the negative cash flows of a project)

NPV = _____

PV(all cash flows)

NPV = ____ + _____

PV(inflows) + PV(outflows)

Non-normal cash flows can cause _____ to occur.

Parabola

____ ____ is the length of time required for an investment's cash flows to cover its costs.

Payback Period

IRR puts profits into a ____ form.

Percentage

If you are picking between two projects, accept the project with the highest ____ NPV. IF not project has a positive NPV, ____them all.

Positive, Reject

SCE: You don't want to maximize ____, because that will take you into too much debt.

Profit

If a project's MIRR is greater than WACC , then the project is ____ and should be _____.

Profitable, Accepted

Payback period is the number of years required to _____ a project's cost. AKA: How long does it take you to get your ____ cash flow back?

Recover, Original

The answers that you receive from MIRR and NPV will be the ___ regarding whether independent projects should be taken and also whether one mutually exclusive project is better than another mutually exclusive project.

Same

Ascending cash flows have more ___ to increases in k than descending cash flows.

Sensitivity

If a project has most of its cash flows coming in the later years, its NPV will decline _____ if the cost of capital increases; but a project whose cash flows come earlier will not be severely penalized by high capital costs.

Sharply

_____ means what it really costs you to be in a project.

Size

A company's _______ ____ ____ is a long-term plan that outlines in broad terms a firm's basic strategy for the next 5 to 10 years.

Strategic Business Plan

For NPV profiles, where profile lines hit the vertical is equivalent to the ____ of the ___ ___ for that profile line.

Summation, Cash Flows

When calculating MIRR, the sum of all the FV's is called the ____ ____.

Terminal Value

TVM stands for?

Time Value of Money

For a firm that has adequate access to the capital markets is it more reasonable to assume reinvestment at the WACC or the IRR?

WACC

If a firm has adequate access to the capital markets, it is more reasonable to assume reinvestment at the ___, and for a firm that does not have adequate access to the capital markets, it is more reasonable to assume reinvestment at the _____.

WACC, IRR

Reinvestment Rates Conclusion: Our conclusion is that the assumption built into the IRR --- that cash flows can be reinvested at the IRR --- is flawed, whereas the assumption built into the NPV-- that cash flows can be reinvested at the _____ is generally correct. Moreover, if the true reinvestment rate is less than the IRR, then the true rate of return on the investment must be less than the calculated IRR; thus, the ___ is misleading as a measure of a project's profitability.

WACC, IRR

The NPV assumes reinvestment at the ____, while the IRR assumes reinvestment at the ____.

WACC, IRR

What is the one weakness with MIRR?

When mutually exclusive project's sizes are unequal, you can't trust MIRR to choose the project that will add the most value.

Payback Period = ____+___

Year Before Full Recovery + (Unrecovered Cost at start of year/Cash Flow during year)

For NPV profiles, will NPV, IRR, and MIRR always agree as to the profitability of a single project?

Yes

If a project's NPV exceeds ____, accept the project.

Zero

NPV is the profit of a project expressed at time __ ( today's) dollars.

Zero

Recall that the IRR is the discount rate that causes the NPV to equal _____, so the discount rate at which the profile line crosses the ____ axis is the project's IRR.

Zero, Horizontal