Financial Decision Models
ways to determine rate of return
-WACC -target rate -project specific risk
3 cash flow types used to estimate NPV
-cash flow from operations -term year one time cash flow -initial cost
limitations to NPV method
-doesnt give true rate of return
advantages of payback method
-easy to use & understand -emphasis on liquidity
advantages of NPV method
-flexible -doesnt have to be a constant rate of return
limitations of payback method
-ignores time value of money -doesnt consider cash flows after the initial investment -reinvestment of cash flows not considered -project profitability not considered
limitations of IRR
-unreasonable reinvestment assumption -inflexible -alternatives are based on interest rates
when NPV is positive you can infer that...
IRR > hurdle PI > 1
accept projects under IRR if
IRR > hurdle rate
hurdle rates for IRR are usually...
WACC
when making an investment decision choose the project depending on
WACC
internal rate of return uses
a single discount rate
the IRR strategy is known to be
aggressive reinvestment strategy
when unlimited capital is available, what projects should be pursued?
all with a positive NPV
why do we use profitability index?
allows you to rank projects
why is there a rate of return desired?
as compensation for risks assumed
finance lease
buying an asset and financing with debt
NPV is stated in terms of
cash flow
profitability index measures
cash flow return per dollar invested
direct cash flow efffects
cash in and cash out
what is different about the "discounted" payback method?
considers the time value of money
indirect cash flow effect
depreciation as a tax deduction
depreciation tax shields can be calculated as
depreciation x tax rate
money saved from depreciation is calculated by....
depreciation x tax rate
capital budgeting
evaluating & selecting the LT investment projects of the firm
operations cash flows include
future annual cash inflows
when borrowing to buy or financing debt, what is true of your debt to equity ratio?
goes up
profitability index is more favorable when...
higher
capital rationing
how limited investment resources are considered as part of investment ranking and selection decisions
rate of return desired is also known as the
hurdle rate
when will projects be accepted?
if they are profitable
when calculating discount of cash for financing options, what do you do with interest expense?
ignore because it is already accounted for the in the discount rate of dbt
accelerated depreciation has what impact on IRR?
increase
decreasing working capital requirements would do what to IRR?
increase
reducing payback period would do what to IRR?
increase
IRR & PV factors have what kind of relationship?
inverse
the discounted payback rate only takes into consideration the periods in which...
it takes to recoup investment
payback period focuses decision makers on
liquidity & risk
is a high/low payback period favorable?
lower
when choosing a finance lease, the most desirable option is one with...
lowest NPV of cost
payback period formula
net initial investment / average incremental cash flow
the disposal of a project is what kind of cash flow?
one time inflow
opportunity cost
potential benefit from a course of action
annual cash inflows from a project can be calculated as
pretax cash x (1-T)
calculation for how much $ we can get for disposing replaced asset
selling price - NBV = gain x tax rate = tax paid selling price - tax paid = net cash proceeds if a loss then there is an additional cash inflow for tax savings
initial cash outlay also includes
shipping training installation
net present value is equal to
sum of PVFCF - costs
how can you determine if a project is profitable?
sum of PVFCF > today's cost
mutually exclusive investments using NPV & IRR may differ if...
the 2 projects have unequal lives and the size of the investment is different
when limited capital is available, what projects should be pursued?
the combination with the max NPV
the cost of initial outlay can be offset by
the disposal of the replaced asset
NPV evaluates....
the dollar amount of the return on an investment
cash flow at time period zero is often equal to
the initial cash outflow
payback period
time required for the net after tax operating cash flows to recover the initial investment of a project
limitation of discounted cash flows
use a single interest rate assumptions which is unrealistic as rates typically fluctuate
does buying equipment impact financial leverage?
yes
when financing an asset, discount cash flows using the following formula:
yield to maturity x (1-T)
IRR can be determined by finding the discount rate that....
yields an NPV of zero
profitability index formula
PV of cash flows / cost (PV) of initial investment
3 general stages of cash flows
1) inception of project (time period zero) 2) operations 3) disposal
two methods of discounted cash flow valuation
1) net present value 2) internal rate of return
the discount rate is determined in advance under which method?
NPV
finance leases must meet
OWNES criteria
decreasing tax credits would do what to IRR?
decrease
when borrowing to buy or financing debt, what is true of your times interest earned?
decreases
when using an operating lease what is true of debt to equity?
decreases since you use ROU asset and liability
when capital rationing is considered, what method should be used?
profitability index
