Finance 2 Exam 1
Cash flow versus accounting income
A firm's true profitability, and hence its future financial condition, depends more on its cash flows than on income as reported in accordance with GAAP. In capital investment decisions, the decision must be based on the actual dollars that flow into and out of the business that are a direct result of the project being evaluated.
What is a perpetuity?
A perpetuity is an annuity that last forever (has no maturity date)—example: usually it says $100 per year over three years
Why should projects with high expected profitability be viewed with some skepticism?
High-profitability projects must have some underlying rationale, such as market dominance or innovation, that justifies the profitability. Even then, under most circumstances, the project's high profitability will be eroded over time be competition.
Changes in current accounts
projects that require additional inventories, and expand patient volumes also lead to additional accounts receivable When a project requires a large positive change in current accounts, failure to consider the net change will result in an overestimate of the project's profitability
Present value (PV)
the beginning amount (current worth) of an investment of a lump sum, an annuity, or a series of unequal cash flows
Incremental cash flow
the business's cash flows in each period if the project is undertaken minus the cash flows in each period if the project is undertaken minus the cash flows if the project is not undertaken The actual estimation process focuses on the cash flows unique to the project being evaluated
Salvage value
the cash flow expected to be realized from selling the project's assets at termination Any cash flow that will arise by virtue of scrap value must be included in the project's cash flow estimates.
Opportunity cost
the cost associated with alternative uses of the same funds. For example, if money is used for one investment, it is no longer available for other uses, so an opportunity cost arises
Shipping and installation costs
the cost to ship or install new equipment etc
Return on investment (ROI)
the estimated financial return on an investment. In capital budgeting analysis, ROI can be measured either in dollars or percentage (rate of) return
Terminal value
the estimated value of the cash flows beyond the truncation point. Sometimes, this is estimated as the liquidation value of the project at that point in time.
Salvage value
the expected market value of an asset (project) at the end of its useful life
Post-audit
the feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations
Nominal (stated) interest rate
the interest rate stated in a debt contract. It does not reflect the effect of any compounding that occurs more frequently than annually
Effective annual rate (EAR)
the interest rate that, under annual compounding, produces the same future value as was produced by more frequent compounding
Payback period
the number of years it takes for a business to recover its investment in a project without considering the time value of money
Net present social value (NPSV)
the present value of a project's social value. Added to the financial net present value (NPV) to obtain a project's total value.
Discounting
the process of finding the current (present) value of a lump sum, an annuity, or a series of unequal cash flows
Compounding
the process of finding the future value of a lump sum, an annuity, or a series of unequal cash flows
Capital budgeting decisions
the process of selecting a business's capital (long-term asset) investments. The list of investments chosen constitutes a business's a business's capital budget.
Time value analysis
the use of time value of money techniques to value future cash flows. Sometimes called discounted cash flow analysis
Strategic value
the value of future investment opportunities that can be undertaken only if the project currently under consideration is accepted.
Which annuity has the greatest present value: an ordinary annuity or an annuity due? Why?
An annuity due because the PV of an annuity due is found by: PV of an ordinary annuity x (1 + I)
What is an annuity?
An annuity is a series of payments of a fixed amount for a specified number of equal periods.
What is the difference between an ordinary annuity and an annuity due?
An ordinary annuity are payments that occur at the end of each period which an annuity due are payments that occur at the beginning of each period.
Which annuity has the greater future value: an ordinary annuity or an annuity due? Why?
Annuity due because it is multiplied by (1 + Rate), which an ordinary An annuity due because the FV of an annuity due is found by: PV of an ordinary annuity x (1 + I)
Why does an investment have an opportunity cost rate even when the funds employed have no explicit cost?
Because one investment decision automatically negates all other possible investments with the same funds
Evaluate the following statement: "Ignoring inflation effects and strategic value can result in overstating a project's financial attractiveness."
By ignoring the effects of inflation on a project and looking at the strategic value, there is a greater chance that you will overestimate the monetary value of the project.
What is compounding? What is interest on interest?
Compounding is the process of finding the future value of a lump sum, an annuity, or a series of unequal cash flows. Interest on interest means that when you earned interest the year before, interest for the following year is calculated based on the amount at the end of year one.
Opportunity costs
must be included in a capital investment analysis The return that a business could earn by investing in alternative investments of similar risks
What is discounting? How is it related to compounding?
Discounting is the process of finding the current (present) value of a lump sum, an annuity, or a series of unequal cash flows. Discounting is the opposite of compounding: If the PV is known, compound to find the FV; if the FV is known, discount to find the PV.
How does the effective annual rate differ from the stated rate?
EAR shows the effects of compounding and Nominal (stated) rate does not.
Explain the four steps in capital budgeting financial analysis.
Estimate the project's expected cash flows--Cost, operating cash flows, ending cash flow Assess the riskiness of the estimated cash flows Given the riskiness of the project, estimate the project's cost of capital (opportunity cost of discount rate).--If the project being evaluated does not have average risk, the corporate cost of capital must be adjusted to reflect the risk differential. Finally, assess the financial impact of the project.
How do expansion and replacement cash flow analyses differ?
Expansion replacement is if you do not have the equipment that you are adding and replacement decision is if you are replacing the existing equipment that could, in theory, continue in operation. With replacement cash flow analyses, you can sell the existing machine so the current market value of the existing asset is a cash inflow in the analysis.
What are three solution techniques for solving lump sum compounding problems?
Future values, as well as most other time value problems, can be solved three ways: by regular calculator, financial calculator, or spreadsheet. Regular calculator: plug in the formula Financial calculator: the future value is found using three of the following five time value input keys: N, I, PV, PMT, and FV. Two places are generally used for answers in dollars or percentages, and four places for decimal answers. The nature of the analysis dictates how many decimal places should be displayed. Spreadsheet: plug the formula into one cell (but put the numbers into individual cells so that the formula accounts for changing values
What are the three techniques for solving lump sum discounting problems?
Regular calculator solution Financial calculator solution Spreadsheet solution
Why is sign convention important in time value analyses?
In more complicated analyses, it is essential to use the proper signs to designate whether a cash flow is an inflow or an outflow. Many financial calculators and some spreadsheet functions require that signs be attached to cash flows in time value analyses, even simple ones, before the calculation can be completed.
Cash flow timing
In most cases, analysts simply assume that all cash flows occur at the end of every year. For projects with regular, easy-to-forecast cash flows, it may be more appropriate to assume that the flows occur every six months or quarterly or even monthly.
What is the primary advantage of classifying capital projects?
It allows managers to organize capital investment proposals by category and cost and then allows each project to be analyzed based on category and cost.
What changes must be made in the calculations to determine the future value of an amount being compounded at 8 percent semiannually versus one being compounded annually at 8 percent?
It would be raised to the power of 2 to account for the 2 periods that it would be compounded this year.
Briefly, how is a project cash flow analysis constructed?
Line 1: System cost Line 2: Related expenses Line 3: Net revenues Line 4: Labor costs Line 5: Maintenance costs Line 6: Supplies Line 7: Incremental overhead Line 8: Depreciation Line 9: Operating income Line 10: Taxes Line 11: Net operating income Line 12: Depreciation Line 13: Net salvage value Line 14: Net cash flow
What are the key differences in cash flow analyses performed by investor-owned and not-for-profit businesses?
Line 8: tax depreciation rather than book depreciation; without reduction by the estimated salvage value Line 10: taxable firms must reduce the operating income on Line 9 by the amount of taxes Line 12: MACRS depreciation amount, because it is a noncash expense, is added back Line 13: the value of the MRI system at the end of Year 5 is the tax book value
What is a lump sum?
Lump sum compounding deals with a single starting amount
What are some typical classifications?
Mandatory replacement (expenditures necessary to replace worn-out equipment) Discretionary replacement (replace obsolete equipment) Expansion of existing services or markets (increase capacity or expand within markets currently Expansion into new services of markets (provide new services or expand into new geographic areas) Environmental projects (comply with government orders, labor agreements, accreditation requirements, etc.) Other (projects that do not fit into other categories)
Project life
Most organizations set an arbitrary limit on the project life assumed in capital budgeting analyses. If the forecasted life is less than the arbitrary limit, but if the forecasted life exceeds the limit, the project life is truncated and the operating cash flows beyond the limit are ignored.
Briefly describe how to calculate net present value (NPV), internal rate of return (IRR), and modified IRR (MIRR).
NPV -Fine the present value of each net cash flow, including both inflows and outflows, when discounted at the project's cost of capital. -Sum the present values. This sum is defined as the project's net present value. -If the NPV is positive the project is expected to be profitable. If it is 0, the project breaks even, and if it is negative the project will be unprofitable. IRR -The discount rate that equates the present value of the project's expected cash inflows to the present value of the project's expected cash outflows; the discount rate that forces the NPV of the project to equal zero. MIRR: -Discount all the project's net cash outflows back to year 0 at the project cost of capital -Compound all the project's net cash inflows forward to the last (terminal) year of the project, at the project cost of capital. This value is called the inflow terminal value. -The discount rate that forces the present value of the inflow terminal value to equal the present value of costs is the MIRR.
What is the rationale behind each method?
NPV: if zero, the project's cash inflows are just sufficient to return the capital invested in the project; provide the required rate of return on that capital; if positive it is making excess cash flows; if negative its cash flows are insufficient IRR: if greater than the project cost of capital, a surplus is expected to remain after recovering the invested capital and paying for its use; if less than, the project imposes a financial cost on the stock holders MIRR: it avoids the potential problems when a project has a non-normal cash flows
What is meant by net present value?
Net present value means the sum or net of the present values of a cash flow stream.
Is it necessary to include depreciation expense in a cash flow analysis by a not-for-profit provider? Explain your answer.
No, because they are tax-exempt, and hence depreciation will not affect taxes and will be added back to the cash flow on line 12, it can be totally omitted from the cash flow analysis.
Do the three methods lead to the same conclusions regarding project profitability? Explain your answer.
No. In general, the MIRR is less than the IRR when the IRR is greater than the cost of capital, but is greater than the IRR when the IRR is less than the cost of capital. IRR overstates the profitability of profitable projects and understates the profitability of unprofitable projects.
What is the role of financial analysis in capital budgeting decision making within for-profit firms?
Owner wealth maximization is the primary goal so the role of financial analysis is clear: Those projects that contribute to owners' wealth should be undertaken, while those that do not should be ignored.
What are its deficiencies when used as the primary evaluation tool?
Payback ignores all cash flows that occur after the payback period. Payback ignores the opportunity costs associated with the capital employed.
How does the periodic rate differ from the stated rate?
Periodic rate is per period while nominal (stated) rate is annual.
What does the term ROI mean?
ROI is return on investment which measures the financial attractiveness of investments.
Describe the net present social value (NPSV) model of capital budgeting.
The NPSV is used when a firm wants to measure the social service provided as well as the commercial service. TNPV= NPV +NPSV And NPSV represents managers' assessment of the social value of a project NPSV is the summer of the present values of each year's social value
Why is project financial analysis important in not-for-profit businesses?
The appropriate goal is providing high-quality, cost-effective service to the communities served. Managers must also know the financial impact up front, rather than be surprised when the project drains the firm's financial resources.
How are opportunity cost rates established?
The cash flows expected to be earned from any investment must be discounted at a rate that reflects the return that could be earned on forgone investment opportunities. The opportunity cost rate applied to investment cash flows is the rate that could be earned on alternative investments of similar risk.
Effects on current business lines
The cash flows that are foregone in order to open another business line Also the incremental net cash flows generated by the new line of business that can be credited to that project
What is payback?
The expected number of years required to recover the investment in a project.
What is post-audit?
The feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations.
Give two examples of financial decisions that typically involve uneven cash flows.
The financial evaluation of a proposed outpatient clinic or MRI facility rarely involves constant cash flows.
How does the future value of a lump sum change as the time is extended and as the interest rate increases?
The future value increases exponentially as well.
What role does the opportunity cost rate play in calculating financial returns?
You take it into account when calculating the present value of inflows.
Does the opportunity cost rate depend on the source of the investment funds?
The opportunity cost rate does not depend on the source of the funds to be invested. Rather, the primary determinant of this rate is the riskiness of the cash flows being discounted.
Describe how present values of uneven cash flow streams are calculated using a regular calculator, using a financial calculator, and using a spreadsheet.
The present value of an uneven cash flow stream is found as the sum of the present values of the individual cash flows in the stream. Regular calculator: PV of each lump sum cash flow can be found using a regular calculator and then these values are summed to find the present value of the stream Financial calculator: input the individual cash flows, in chronological order, into the cash flow register, where they usually are designated as CF0 and CFj; enter the discount rate, push the NPV key Spreadsheet: cash flow values must be entered into consecutive cells in the spreadsheet. The discount rate must be placed into a cell. Then, use the function wizard to select Financial and NPV. The NPV function assumes that cash flows occur at the end of each period, so NPV is calculated as of the beginning of the period of the first cash flow specified in the range.
What are the benefits of payback?
The shorter the payback, the more quickly the funds invested in a project will become available for other purposes and the more liquid the project. Cash flows expected in the distant future are generally regarded as being riskier than near-term cash flows, so shorter payback projects generally are less risky than those with longer paybacks.
Differentiate between dollar return and rate of return.
The two different ways to express ROI: Dollar return: the cost of the X-ray machine must be compared to the present value of the expected benefits Present value of inflows - cost of machine Rate of return: measures the interest rate that must be earned on the investment outlay to generate the expected cash inflows; provides the expected periodic rate of return on the investment.
Should capital budgeting analyses look at only one breakeven or profitability measure? Explain you answer.
The uncertainties in the cash flow estimates for many projects are such that the resulting quantitative measures can only be viewed as rough estimates. Therefore, looking at more than one will give you a better picture of the data.
How does the present value of a lump sum to be received in the future change as the time is extended and as the interest rate increases?
The values get smaller
Evaluate the following statement: "The difficulty in calculating numerous breakeven and profitability measures restricts the amount of information available in capital budgeting analyses."
There are many other measures commonly used in project financial analyses.
Describe the construction and use of a project scoring matrix.
This attempts to capture both financial and nonfinancial factors. They divide them into categories and give each category a score and this score is reported to managers.
Inflation effects
inflation effects can have a considerable influence on a project's profitability The most effective way to deal with inflation is to apply inflation effects to each cash flow component using the best available information about how inflation rates with much precision, errors will probably be made.
Why are post-audits important to the efficiency of a business?
When a forecast is made, the department director and medical staff are putting their reputations on the line. If costs are predicted levels and volume is below expectations, the managers involved will strive, within ethical bounds, to improve the situation and to bring results into line forecasts.
What happens to the value of a perpetuity when interest rates increase or decrease?
When the interest rate increases, the value decreases and vice versa.
What role does project size (cost) play in the classifications?
Within each category, projects are classified by size: larger projects require increasingly detailed analyses and approval at a higher level within the hospital.
Is the calculation of financial return an application of time value analysis? Explain your answer.
Yes because you have to calculate net present value in order to get that.
Can capital budgeting tools be used in different settings? Explain your answer.
Yes, because these tools can help make a number of different types of decisions in addition to project selection.
Why is semiannual compounding better than annual compounding from an investor's standpoint?
You make money on the interest twice a year.
Incremental cash flow
a cash flow that arises solely from a project that is being evaluated and hence should be included in the project analysis.
Nonincremental cash flow
a cash flow that does not stem solely from a project that is being evaluated. Nonincremental cash flows are not included in a project analysis.
Sunk costs
a cost that has already occurred or is irrevocably committed. Sunk costs are nonincremental to project analyses and hence should not be included.
Time line
a graphical representation of time and cash flows. May be an actual line or cells on a spreadsheet
Strategic value
a major source of hidden value that stems from future investment opportunities that can be undertaken only if the project currently under consideration is accepted. Other gains that they make from completing a project—entering a new market, etc.
Modified internal rate of return (MIRR)
a project ROI measure similar to IRR but using the assumption of reinvestment at the cost of capital
Net present (NPV)
a project return-on-investment (ROI) metric that measures the time value adjusted expected dollar return
Internal rate of return (IRR)
a return-on-investment (ROI) metric that measures expected rate of (percentage) return
Annuity
a series of payments of a fixed amount for a specified number of equal periods
Perpetuity
an annuity that lasts forever (has no maturity date)
Annuity due
an annuity with payments occurring at the beginning of each period
Ordinary (regular) annuity
an annuity with payments occurring at the end of each period
Project scoring
an approach to project assessment that considers both financial and nonfinancial factors
Sunk costs
an outlay that has already occurred or has been irrevocably committed, so it is an outlay that is unaffected by the current decision to accept or reject a project.
Payment (PMT)
in time value analysis, the dollar amount of an annuity cash flow
Periodic interest rate
in time value of money analysis, the interest rate per period. For example, 2 percent quarterly interest, which equals an 8 percent stated (annual) rate.
Terminal value
when a project's cash flows are arbitrarily truncated, an estimate of the value of the cash flows beyond the truncation point
