FINC Exam 3 Qualitative

NPV-Forecasting Risk

The possibility that errors in projected cash flows will lead to incorrect decisions AKA "estimation risk"

NPV formula

Total Present Value of Future Cash Flows - Initial Cost of Investment

Side Effects

When a company launches a new product, there could be "spillover" impacts on the sales of existing products

If NPV > 0 then

accept the project

Problems with Scenario Analysis

considers only a few possible outcomes assumes perfectly correlated inputs -all bad values occur together and all good values occur together - most likely have some bad value and some good focuses on stand-alone risk, although subjective adjustments can be made

Net Working Capital (NWC)

current assets - current liabilities

NWC

current assets - current liabilities (Cash, Accounts Receivable, Inventory) - (Accounts Payable)

Sensitivity Analysis

investigation of what happens to NPV when only one variable is changed

NPV

net present value

pro forma balance sheet

provides a firm a sense of how its activities will affect its ability to meet its short-term liabilities and how its finances will evolve over time

Payback Period

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

Erosion

the cash flows of a new project that come at the expense of a firm's existing projects; "product cannibalization"

Time Value of Money (TVM)

the concept that money available today is worth more than the same amount tomorrow

Scenario Analysis

the determination of what happens to NPV estimates when we ask what-if questions

Non-Conventional Cash Flows

when there are project costs incurred both at the beginning of the project and again in the later years

Conventional Cash Flows

where the costs of the project (i.e., the investment) are all paid at the beginning of the project and the benefits are received in the future years

IRR Advantages

- Preferred by executives Intuitively appealing Easy to communicate the value of a project - If the IRR is high enough, may not need to estimate a required return - Considers all cash flows - Considers time value of money - Provides indication of risk

Advantages of Payback Rule

- easy to understand - adjusts for uncertainly of later cash flows - biased towards liqiudity

pro forma financial statements

- financial statements projecting future years' operations - summarizes all relevant information for a project - found using assumptions/projections

Sensitivity Analysis strengths

- identifies dangerous variables - gives some breakeven information

if NPV = 0 then

- project inflows are sufficient to repay invested capital and provide required rate of return

Sensitivity Analysis weaknesses

- says nothing about the likelihood of change in variable - ignores relationship among variables

Depreciation Tax Shield

- tax savings that result from the depreciation deduction - calculated as depreciation multiplied by the corporate tax rate

Opportunity Cost

- the most valuable alternative that is given up if a particular investment is undertaken

Scenario Analysis examines:

- worst case - base case/ most likely case - best case Provide a range of possible outcomes

Advantages of Profitability Index

-Closely related to NPV, generally leading to identical decisions -Easy to understand and communicate -Useful in capital rationing

Disadvantages of Payback Rule

-Ignores the time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond the cutoff date -Biased against long-term projects, such as research and development, and new projects

MIRR 3 Methods

1. Discount Approach = Discount future outflows to present and add to CF0 2. Reinvestment Approach = Compound all CFs except the first one forward to end 3. Combination Approach = Discount outflows to present; compound inflows to end

Sunk Cost

A cost that has already been incurred and cannot be recouped - should NOT be considered in an investment decision

Payback Period Decision Rule

Accept if the payback period is less than predetermined time limit

IRR Decision Rule

Accept the project if the IRR is greater than the required return

After-Tax Salvage Value

At the end of the project, if there is value in this fixed asset, the ————— needs to be determined

If the salvage value is different from the book value of the asset, then there is a tax effect which impacts ___ ___

Cash flows

With IRR calculations, you are only given...

Cash flows

Modified Internal Rate of Return (MIRR)

Controls for some problems with IRR

NWC will ___ when liabilities increase

Decrease

NPV is the ___ method

Dominant (best way to decide if you should accept/reject)

Operating Cash Flow (OCF)

EBIT + Depreciation - Taxes

Negative Sides Effects, AKA

Erosion

T/F: Most investment projects will not impact a firm's working capital

FALSE

T/F: The pro forma income statement has an interest expense

FALSE - not included because it is a financing expense and not a component of operating cash flow

Sensitivity Analysis shows:

How changes in one input variable affect NPV or IRR - each variable is fixed except one

Profitability Index Decision Rule

If PI > 1.0, Accept

Disadvantages of Profitability Index

May lead to incorrect decisions in comparisons of mutually exclusive investments

Profitability Index

Measures the benefit per unit of cost, based on the time value of money

Negative Side Effects

New product decreases the sales of existing products

Positive Side Effects

New product increases the sales of existing products

Profitability Index Formula

Present Value of Net Cash Flows / Absolute Value of Initial Investment

What does NPV represent?

Present value of all future cash flows minus the cost of the investment; How much value is created by undertaking an investment?

Risk with NPV Analyis

Projected future cash flows drive the NPV result, how do you know the projected estimates are accurate?

Net Salvage Cash Flow =

Selling price - (selling price - book value)(corporate tax rate)

Steps to find Payback Period

Step 1: Estimate the initial cost of the investment plus the future cash flows Step 2: Subtract the future cash flows from the initial investment for as many months/years as required to recover the initial investment (OR divide if all cash flows are the same for months/years)

Steps to find NPV

Step 1: estimate expected future cash flows Step 2: estimate required rate of return for projects of this risk level Step 3: find present value of cash flows and subtract initial investment

T/F: If a project has a profitability index of 1.0, then this project has an internal rate of return that equals that required return

TRUE

T/F: If a project has an internal rate of return that is greater than the required return, then the net present value of the project is positive

TRUE

T/F: If the project being considered is using an asset that has alternative uses and value (opportunity cost), then it is a relevant cash flow

TRUE

T/F: NPV and IRR will generally give the same decision

TRUE Exceptions: - non-conventional cash flows - mutually exclusive projects

Required rate of return...

Takes into account the risk level of the project

A project has a required payback period of three years. Which one of the following statements is correct concerning the payback analysis of this project?

The cash flow in Year 2 is valued just as highly as the cash flow in Year 1.

Internal Rate of Return (IRR)

The discount rate that makes NPV = 0