Finance Test #2 chapter 8

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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


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