Corp. Finance ex. 2

Payday loans are finance fees

True

Present values are _____, rather than compounded.

discounted

(PV of the Project - Cost) > 0, we have _______ economic profit, and we should _________ the project as it will benefit society.

positive, accept

The payback period is the length of time it takes an investment to generate sufficient cash flows to enable the project to:

recoup its initial cost.

Total revenues minus explicit costs

Accounting profit

Biases the firm toward short term projects and hence increases the firm's liquidity. Very easy rule

Advantages of the payback period

Truth in lending laws require that rates be stated as... they are an interest rate that is annualized using simple interest. The rate we would be charged as if we would be charged simple interest. Banks lie to us because we are charged compound.

Annual Percentage Rates

Your credit card charges you 1.50 percent interest per month. This rate when multiplied by 12 is called the:

Annual percentage rate

A level stream of cash flows (denoted as C) for a fixed period of time. All payments must be the same. All cash flows must be evenly spaced. CF must stop at some point (Paid off)

Annuity

Interest earned on both the initial principal and the interest reinvested from prior periods is called:

Compound interest

Identify the relationship (direct, indirect, or unrelated) between each of the following pairs of variables as they relate to the time value of money: Present Value and Future Value Present Value and Discount Rate

Direct relationship, inverse relationship

The internal rate of return is defined as the:

Discount rate which causes the net present value of a project to equal zero

Total revenues minus explicit and implicit (opportunity) costs. Generally, economic profit will be less than accounting profit because it includes extra costs.

Economic profit

An interest rate that is annualized using compound interest.

Effective annual interest rate (or EAR)

An annuity is best defined by which one of the following definitions:

Equal payments paid at the end of regular intervals over a stated time period

"investing" "saving"

Future value

If the project gives us a greater return than the alternative, we should invest in the project according to the:

IRR Rule

Which one of the following will decrease the net present value of a project?

Increasing the project's initial cost at time zero.

The difference between a firm's future cash flows if it accepts a project and the firm's future cash flows if it does not accept the project is referred to as the project's:

Incremental cash flows.

It means we can only choose one.

MUTUALLY EXCLUSIVE PROJECTS

By forgoing the cash today, you are giving up the opportunity to use it for some alternative end

Opportunity cost

A stream of level cash payments that NEVER END. (ex. British consol bonds, and stocks because they are going concerns) Cash flows must be the same amount Cash flows must be evenly spaced CF NEVER stops

Perpetuity

Means that our investment is better than the next best alternative; an economic loss means that we would be better-off allocating our resources elsewhere.

Positive economic profit

Which one of the following indicates that a project is expected to create value for its owners?

Positive net present value

"Debt" "Buying something today"

Present value

The value today of cash flow received in the future The value of money in the future, today. (promised $100 a year from today, so today it means we have $0 today) We may not even receive the money. Receivables are not this. This is important because we live in today, not tomorrow. Have to do with taking on debt or paying for something.

Present value (PV)

The internal rate of return is unreliable as an indicator of whether or not an investment should be accepted given which one of the following?

The investment is mutually exclusive with another investment under consideration.

Alcoa is considering a project that has an NPV of $32,600, an IRR of 15.1 percent, and a payback period of 3.2 years. The required return is 14.5 percent and the required payback period is 2.5 years. Which one of the following statements correctly applies to this project?

The payback decision rule could override the accept decision indicated by the net present value

How long does it take us to pay off the initial cost? It is the amount of time required for an investment to generate cash flows sufficient to recover its initial cost. We want to pick the project that pays us back as quickly as possible. Rule: An investment is acceptable if its calculated payback period is less than some prespecified number of periods.

The payback period

-Estimating the FCFs (Create cash flows for the next 30 years from now? You have to guess the cash flows 30 years from now). -Identifying option characteristics (ex. Real options) (like buying a friend's car before he tries selling it to anyone else) MOST IMPORTANT ISSUE WITH IT. -Estimating an appropriate discount rate. (small mistakes with r, since we are dividing by r, makes a big difference.)

The primary challenges of NPV

If a project has a net present value equal to zero, then:

The project earns a return exactly equal to the discount rate.

Interest that is earned on the interest that has already been paid. Snowball effect.

Compound interest

-Non-conventional cash flows (Negative cash flows after time period 0) which can cause the IRR to produce multiple solutions to NPV = 0. Ex. Restaurant, hotel, and casino industries. You can have more than one IRR's here. -Cannot use IRR to compare mutually exclusive investment projects (we can choose project A or B, but we can't do both.). ---NPV and IRR often conflict in these circumstances. And we pick NPV > IRR) -Can be difficult to compare across projects if: -Initial outlays are different -Investments have different useful lives. -The timing of cash flows is different across projects.

Cons of IRR

It ignores the time value of money. Benchmark payback period is arbitrary; there is no economic basis for its determination. Ignores cash flows beyond the cut off date. Biases against long term projects such as research and development

Disadvantages of the payback period

The rate of return promised by a lender to a borrower for the use of their assets.

Interest rate

The discount rate that makes the net present value of an investment (projects cash flows) equal to zero. As it turns out the yield to maturity is the IRR for a bond. It provides us with the expected return for the project. It gives us an idea of how high the required rate of return needs to be before the project is unprofitable. -Picks an interest rate and shows you what interest rate you want to accept or reject a project.

Internal rate of return

The value of a firm's assets is equal to the present value of all of the current and future free cash flows, just like any other asset. This answers capital budgeting decision rules. the difference between an investment's market value and its costs. A dollar measure of an investment's effect on the value of a company's assets. A measure of how much the pie grows.

Net Present Value

Popeye's Chicken is considering two projects. Project One consists of creating an outdoor eating area on the unused portion of the restaurant's property. Project Two would use the same unused space to create a drive-thru service window. When trying to decide which project to accept, the firm should rely most heavily on which one of the following analytical methods?

Net present value

Instead of cash flows happening at the end of the period, cash flow happens at the BEGINNING of the period. STARTS RIGHT NOW.

Perpetuity Due

The ratio of the present value of the project's free cash flows (ex. PV) and the absolute value of the initial cost of a project. Measures a project's "Bang for the buck" Rule: Invest if greater than or equal to 1. It can only use this if companies have relatively similar-sized projects and cost around the same amount.

Profitability index (PI)

-Closely related to NPV; which often leads to identical decisions. -States the decision in terms of a rate of return which is often helpful.

Pros of IRR

Is the minimum return that an individual will accept to place their money in a particular security or project.

Required rate of return

Interest earned only on the initial investment, no interest earned on interest. We will never earn this this way.

Simple interest

The amount of investment is worth after one or more time periods. How much money (consumption) we give up today is going to be worth in the future. (use this for saving and retirement) For spending and saving money.

The future value of money (FV)

Your grandmother has promised to give you $10,000 when you graduate from college. She is expecting you to graduate three years from now. What happens to the present value of this gift if you speed up your graduation by one year and graduate two years from now instead?

The present value will go up.

This refers to the concept that a dollar today is worth more than a dollar promised sometime in the future. We want our money now, not later.

Time value of money

The relationship between the present value and the time period is best described as:

inverse

" " is referred to as the "cost of capital" this is where "opportunity cost" sits

r