FIN3403 Chap 9, 10, & 14
the payback period is a kind of __________ measure
"break-even"
What is the present value of $12,950 to be received 3 years from today if the discount rate is 5 percent?
$11,186.70
What is the present value of $20,000 to be received 5 years from today if the discount rate is 8 percent?
$13611.67
An investment will yield $1,000 in 10 years. The current rate of interest on the investment is 7%. What is the value of the investment today (present value)?
$508.35
how do we get a firm's WACC?
(1) Calculate the firm's cost of equity and cost of debt. (2) weight these by the proportion of a firm's capital structure (total market value) which is equity and the proportion which is debt. (3) Sum the weighted cost of equity and cost of debt to get the firm's cost of capital (WACC). Make sure the adjust cost of debt to 'after-tax cost of debt' in this step.
How do you assess the NPV of a project?
(1) Estimate all the current and future cash flows from the project (2) Discount them all based on the appropriate discount rate and their maturity (3) Sum them, and you have NPV!
Ranking of Best Rules
(1) NPV Rule (2) IRR Rule (3) ROA Rule or similar (4) Payback Rule*
What does the Discounted Cash Flow valuation state you are going to do?
(1) estimate (or be given cash flows) (2) discount them appropriately based on their maturity and (3) sum the discounted cash flows to get to a valuation of an asset or investment opportunity.
Which one of the following is a correct method of computing operating cash flow (OCF)? Assume there is no interest expense.
(Sales − Costs) (1 − T) + (Depreciation) (T)
Advantages of the Discounted Payback Period Rule
1. Easy to understand. 2. Adjusts for uncertainty of later cash flows. . 3. Biased toward liquidity.
Disadvantages of the Discounted Payback Period Rule
1. Ignores the time value of money. 2. Requires an arbitrary cutoff point. 3. Ignores cash flows beyond the cutoff date. 4. Biased against long-term projects, such as research and development, and new projects.
A firm is estimated to have income of $1,000,000, $2,000,000, and $3,000,000 from a project over the next 3 years. The total assets in place for the project are $23,000,000 and will not change over time. (1): What is the project's ROA? (2): If the firm uses the ROA rule, should the firm accept the project if the company's hurdle rate for projects is 14% (ROA Rule)? (3): Should the firm accept the project if the firm's expected rate of return on equity (discount rate) is 12%,the project's cost is $4,000,000 today and the firm uses the NPV rule? (4): Using the information in (3) above, should the firm accept the project based on the payback rule if the firm requires complete payback within 2 years? What if the firm requires payback in 3 years?
CF_0 CF_1 = 1,000,000 CF_2 = 2,000,000 CF_3 = 3,000,000 NPV = CF_0 + CF_1/(1+r)^1 + CF_2/(1+r)^2 + CF_3/(1+r)^3 1) Project ROA = Project CF/Total Assets =$1,000,000 + $2,000,000 + $3,000,000/$23,000,000 = $6,000,000/$23,000,000 = .26 2) ROA Rate = Accept 3) CF_0 = $4,000,000 NPV = $4,000,000 + 1M.1,1^1 + 2M/1.1^2 + 3M/1.1^3 NPV = $623
Capital Budgeting
Describes the investment decisions of the corporation; it is the process of planning and evaluating expenditures on assets whose cash flows (cost and/or benefits) will take place over more than one year
Suppose we are asked to decide whether a new consumer product should be launched. Based on projected sales and costs, we expect that the cash flows over the five-year life of the project will be $2,000 in the first two years, $4,000 in the next two, and $5,000 in the last year. It will cost about $10,000 to begin production. We use a 10 percent discount rate to evaluate new products. What should we do here?
Given the cash flows and discount rate, we can calculate the total value of the product by discounting the cash flows back to the present: Present Value = ($2000/1.1) + ($2000/1.1^2) + ($4000/1.1^3) + ($4000/1.1^4) + ($5000/1.1^5) = $1818 + $1653 + $3005 + $2732 + $3105 = $12,313 The present value of the expected cash flows is $12,313, but the cost of getting those cash flows is only $10,000, so the NPV is $12,313 − 10,000 = $2,313. This is positive; so, based on the net present value rule, we should take on the project.
Suppose you need to have $1,000 in two years. If you can earn 7 percent, how much do you have to invest to make sure you have the $1,000 when you need it? In other words, what is the present value of $1,000 in two years if the relevant rate is 7 percent?
Given this, we can solve for the present value: Present value = $1,000/1.1449 = $873.44 Therefore, $873.44 is the amount you must invest to achieve your goal.
Which one of the following indicates an accept decision for a project?
IRR = 15.6 percent; Required return = 15 percent
The rank of rules
IRR and ROA Rule or similar are somewhat subjective, but NPV is definitely the best rule, Payback the worst, and IRR and ROA type rules in between the two.
why is capital budgeting decisions so important
Impact of decision is long-term. Usually involves large expenditure amounts. Reflect commitment to major strategic decisions.
Discounted Payback Period
The length of time required for an investment's discounted cash flows to equal its initial cost. The discounted payback period is the length of time until the sum of an investment's discounted cash flows equals its cost. The discounted payback period rule is to take an investment if the discounted payback is less than some cutoff. The discounted payback rule is flawed, primarily because it ignores cash flows after the cutoff.
Discounted Cash Flow (DCF)
The process of valuing an investment by discounting its future cash flows.
Incremental Cash Flows
The relevant cash flows from a project can be measured as the difference between the firm's cash flows given the project is undertaken less the firm's cash flows given the project is not undertaken. In other words, any cash flows that exist whether or not the project is undertaken are not important and should not be considered within our project NPV analysis.
Suppose you need $400 to buy textbooks next year. You can earn 7 percent on your money. How much do you have to put up today?
We need to know the PV of $400 in one year at 7 percent. Proceeding as in the previous example: Present value × 1.07 = $400 We can now solve for the present value: Present value = $400 × (1/1.07) = $373.83
Return on Assets (ROA)
a measure of profit per dollar of assets.
Hurdle rate
a rate at which or above projects will be accepted. If ROA > hurdle rate then accept If ROA < hurdle rate then reject
Which one of the following is an example of erosion?
a store's decline in wool sweater sales because the store started selling fleece jackets
The point where the net present values of two mutually exclusive projects are equal is referred to as the
crossover point
Which one of the following will increase a firm's aftertax cost of debt financing?
decrease in the corporate tax rate
discounted payback is the time it takes to break even in a __________ sense
economic or financial
A firm has two components in its capital structure
equity and debt
(1) The fee paid to a consultant to evaluate firm projects. (2) Prior taxes and expenses on land, which may be developed into residential housing. (3) Prior lawsuits settled for a coal mine, which now may be closed (expected costs from future lawsuits should be taken into account, but not the costs of prior lawsuits already paid/settled).
examples of sunk cost
pro forma financial statements
financial statements projecting future years' operations
Sunk costs
have already been incurred. Thus, decisions today should not be based on sunk costs, as these costs have already occurred and are not dependent on the project. A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.
Firm's which are higher credit risk is
high of bankruptcy
Based on the payback rule, an investment is acceptable if its calculated payback period
is less than some pre-specified number of years.
An investment should be accepted if the net present value
is positive and rejected if it is negative.
For an independent project, the NPV
is the difference between the project's cost and its market value.
an investment should be accepted if the net present value is
positive and rejected if it is negative
more descriptive name for Capital budgeting
strategic asset allocation
Which one of the following should be excluded from the cash flows of a project?
sunk costs
stand-alone principle
the assumption that evaluation of a project may be based on the project's incremental cash flows
erosion
the cash flows of a new project that come at the expense of a firm's existing projects
Weighted Average Cost of Capital (WACC)
the discount rate at which a firm should discount its own cash flows on all projects (to decide to accept or reject these projects).
profitability index (PI)
the present value of an investment's future cash flows divided by its initial cost. Also called the benefit-cost ratio
benefit-cost ratio
the profitability index of an investment project
Suppose you need $1,000 in three years. You can earn 15 percent on your money. How much do you have to invest today?
1/(1 + .15)3 = 1/1.5209 = .6575 The amount you must invest is thus: $1,000 × .6575 = $657.50
The Even Cut Co. is considering opening a new plant to produce lawn mowers. The initial cost of the project is $6 million. This cost will be depreciated straight-line to a zero book value over the 15-year life of the project. The net income of the project is expected to be $137,000 a year for the first four years and $538,000 for years 5 through 15, respectively. What is the average accounting return on this project?
14.37 percent
What is the NPV Decision Rule?
Accept a project if the NPV is positive (NPV > 0 implies "Accept"). Reject a project if the NPV is negative (NPV < 0 implies "Reject").
What would the IRR rule be?
Accept projects if the IRR is greater than the project's required rate of return (also called hurdle rate). Reject projects if the IRR is less than the project's required rate of return (also called hurdle rate). An IRR greater than the project's discount rate implies a positive NPV, and visa versa. IRR > discount rate (r) implies "Accept" IRR < discount rate (r) implies "Reject".
The payback rule states that
An investment should be undertaken if the payback period is less than some arbitrarily specified amount of time.
Is payback a good measure?
No, not at all! (1) Arbitrarily specify time in years (2) Cash flows are not discounted so inflation, opportunity cost of investing, expected future interest rates, risk of the company, etc. are not taken into account. In other words, the time value of money and firm risk are both not appropriately considered. (3) All Cash flows after the payback period are ignored (there could be $1.00 or $1,000,000,000 remaining after the payback period and we still treat the decision exactly the same)
When calculating payback, are CFs discounted?
No; payback is therefore the simplest rule
Which one of the following statements related to the profitability index (PI) is correct?
PI is used to rank positive NPV projects when the available funds are limited.
Which one of the following statements correctly applies to the modified internal rate of return (MIRR)?
The MIRR depends upon an external discount rate, an external compounding rate, or both.
There are multiple ways to answer capital budgeting questions, but as we will see the BEST way is the use of
The Net Present Value
Opportunity Cost
The amount of benefits foregone due to undertaking the project. We do need to take opportunity costs into account.
Net Present Value (NPV)
The difference between an investment's market value and its cost.
Internal rate of return (IRR)
The discount rate that makes the NPV of an investment zero; it is sometimes called the discounted cash flow (DCF) return; IRR is the discount rate which solves the NPV equation at a given NPV (for bonds YTM is the discount rate which solves the bond pricing formula at a given bond price).
The Payback period of a project is
the total time in years it takes to get one's investment in a project back; the amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
We should only measure incremental cash flows
those which are new only because of the projects, in assessing a project's NPV and deciding to accept/reject the project.
