FINA Test 3

What are the disadvantages of Payback Period?

Does not measure value, Does not fully adjust for TVM, Does not fully adjust for risk, No clear accept/reject decision, and Ignores later CFs

Dividend decision

If you can't find investments that make your minimum acceptable rate, return the cash to owners of your business

Investment decision

Invests in assets that earn a return greater than the minimum acceptable hurdle rate

Identify which of these are the relevant cash flows when considering a capital budgeting project.

Lost rent from retail facility, remodeling expenses for new store, increase in inventory, and expected salvage value of manufacturing equipment

What are the advantages of Payback Period?

Measures Liquidity, Easy to communicate, Does not require all CFs, Does not require discount rate, Does not require complex calculations, and Can be used to compare mutually exclusive projects

The "gold standard" of investment criteria refers to:

NPV

Steps in the Capital Budgeting Process

1. Proposal generation 2. Review and analysis 3. Decision making 4. Implementation 5. Follow-up

Capital rationing may be beneficial to a firm if it

weeds out proposals with weaker or biases NPVs

True or False: Net present value (NPV) is a sophisticated capital budgeting technique; found by adding a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital.

False

Financing decision

Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations

What are the advantages of NPV?

Gives a clear accept/reject decision, Uses all cash flows, Adjusts for risks (with discount rate), and Adjusts for TVM

True or False: The Internal Rate of Return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0

True

True or False: The multiple IRR problem occurs when the signs of a project's cash flows change more than once.

True

The primary purpose of capital budgeting is to:

maximize the shareholders' wealth

According to the article, "Sunk cost fallacy: Throwing good money after bad," how can banks limit losses from bad loans? 1. reduce provisions for non-performing loans 2. make fewer loans to businesses 3. increase bank executive turnover

3. increase bank executive turnover

A corporation is contemplating an expansion project. The CFO plans to calculate the project's NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the corporation's cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows?

Any opportunity costs associated with the project

What are the advantages of IRR?

More intuitive than NPV, Gives a clear accept/reject decision for independent projects, Uses all Cash flows, Does not require a discount rate (for calculation), and Adjusts for TVM and therefore risk (in comparing to hurdle rate that adjusts for risk)

Mutually Exclusive

Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

What are the disadvantages of NPV?

Requires complex calculations, Requires a lot of data (estimates of all CFs and r), and Dollar value is not always intuitive

What are the disadvantages of IRR?

Requires complex calculations, Requires a lot of data (estimates of all CFs), Only works for normal cash flows, Requires discount rate (for decision), and Does not always work for mutually exclusive projects

Which of the following statements is correct for a project with a negative NPV?

The cost of capital exceeds the IRR

True or False: It should not usually be clear whether we are describing independent or mutually exclusive projects in the following chapters because when we only describe one project then it can be assumed to be independent

False

True or False: NPV assumes intermediate cash flows are reinvested at the cost of equity, while IRR assumes that they are reinvested at the cost of capital

False