Fin 330

For a normal project with positive future cash flows, the EAC is the annualized NPV of the project.

This metric is sometimes used to compare projects that have different initial costs and different useful lives.

What rule can generate incorrect accept/reject decisions if the project's cash flows change signs?

IRR

The __________ is the rate of return a firm must earn on its investment in order to maintain the market value of its stock

cost of capital

A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is:

-2000

Assume you have two projects with different lives. Project A is expected to generate present value cash flows of $5.2 million and will last 7 years. Project B is expected to generate present value cash flows of $3.8 million and will last 5 years. Given a required return of 9%, Project A has an equivalent annual annuity of __________ which is __________ than Project B.

1.03319 million better

A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by:

A series of inflows

What determines the amount of interest the company pays to service a specific bond issue?

Coupon Rate

All things equal, as interest rates increase, the number of viable capital budgeting projects a firm will find available

DECLINES

One method that can be used to evaluate capital budgeting projects with different lives is to convert the project's cash flows to a level annual cash flow that has the same present value as the project's overall cash flows. This annual cash flow is known as the:

Equivalent Annual Annuity

When resources are limited you should select the projects with the

Highest NPV

Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as:

Independent Projects

Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. What is the investment's internal rate of return?

Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. The investment's internal rate of return is 10%. When you have a series of cash flows that represent an annuity it is very easy to calculate the IRR with your financial calculator using the following inputs: PV = -$16,000 N = 8; FV = 0 PMT = $3,000 CPT I/Y, which gives you 10.0082 or approximately 10%. Note that you would then compare this interest rate to your required return or hurdle rate to determine whether or not to accept this project.

Which of the following decision rules is always correct because it is directly tied to the goal of maximizing shareholder wealth?

NPV Rule

What metric tells you how much "bang for your buck" you will get when you are resource constrained?

PI - profitability index

Any project that generates a _____ NPV will provide the firms's required rate of return since it was used as the discount rate to compute the present value of the project's cash flows

POSITIVE

What rule ignores the time value of money and can be inaccurate as well, particularly in rejecting good projects that have large cash flows occurring later in the project's life

Payback Rule

Assume you have two projects with different lives. Project A is expected to generate present value cash flows of $5.2 million and will last 7 years. Project B is expected to generate present value cash flows of $3.8 million and will last 5 years. Given a required return of 9%, Project A has an equivalent annual annuity of __________ which is __________ than Project B.

Project A: PV = -$5.2; N = 7; I / Y = 9%; FV = 0; CPT PMT and you get $1.03319 million Project B: PV = -$3.8; N = 5; I / Y = 9%; FV = 0; CPT PMT and you get $.97695 million Project A should be selected since it has a higher EAA.

Software Design Inc. is considering a number of capital budgeting projects. However, the company is currently constrained by the number of programmers that it employs. The company has 20 programmers on its staff and will not be able to hire any new programmers in the near future. Which of the following methods should the company use to choose which projects to accept?

Rank the projects based on profitability index (PI) and select the highest PIs

A firm has undertaken a project with an initial investment of $100,000. The firm's cost of capital is 14% 1 - 50000 2- 65000 3 - 90000

The NPV for this project is $54,623. You calculate the NPV for this project by subtracting the initial investment from the present value of the project's cash flows calculated using the firm's cost of capital. So for this project the; NPV = $50,000/(1.14) + $65,000/(1.14)2 + $90,000/(1.14)3 - $100,000 = $43,860 + $50,015 + $60,748 - $100,000 = $54,623

A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is:

The payback period of the project is 3.5 years. The payback period is the length of time it takes to recover the initial investment so in this case you see that a total of $40,000 is recovered in the first three years, which leaves $5,000 to be recovered. In the fourth year, you will generate $10,000 so the fraction of the year required to capture the remaining $5,000 investment is $5,000/$10,000 or 0.5. The payback period is, therefore, 3.5 years.

A conventional cash flow pattern associated with capital investment projects consists of an initial outflow followed by:

a series of inflows

The minimum return that must be earned on a project in order to leave the firm's value unchanged is:

discount rate

One method that can be used to evaluate capital budgeting projects with different lives is to convert the project's cash flows to a level annual cash flow that has the same present value as the project's overall cash flows. This annual cash flow is known as the:

equivalent annual annuity

Capital budgeting is the process of

evaluating a firms investment choices

Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the

firm's cost of capital

If the IRR exceeds the cost of capital the project is expected to

generate return sufficient to warrant investment

the rate that makes the net present value equal to zero

internal rate of return (IRR)

The coupon rate has no bearing on the cost of capital other than

its impact on the YTM

The _______ generates a percentage return and helps resolve problems associated with multiple IRRs occurring when the signs on cash flows change direction

modified IRR

NPV Formula =

project's cash flows - initial investment

The first step in the capital budgeting process is:

proposal generation

Where all project cash flows are negative, then the lower the EAC is,

the less costly the project is to operate per year

Capital Rationing is the process of

using limited cash to select among investments available

The IRR does not establish a minimum required return BUT

will instead be compared to the cost of capital