Finance 301 test 3

Drawbacks of IRR rule

-When projects have different scales -Projects have different time horizons ---IRR is "rate", but doesn't tell the amount of value created by the project -The investment decision based only on IRR is myopic -Under nonconventional cash flows, there may exist multiple IRRs

Components relevant to operating activities

-accounts receivable -inventories -accounts payable

Cash flow from capital expenditure

-relate to the purchase of machine/equipment/plants -incurred at the beginning or end of the project -if you sell the machine for more than its BV, you receive after-tax cash inflow

In this question, when there is a conflict of the investment decisions among the different investment criteria, which rule should you use ultimately?

NPV NPV rule is most accurate and reliable

Advantages and disadvantages of payback

A: Easy to understand -Adjusts for uncertainty of later cash flows -Biased toward liquidity D: Ignores time value of money -Requires an arbitrary cutoff point -Ignores cash flows beyond cutoff date -Biased against long term projects

IRR Decision rule

-Rate of return that sets the NPV of an investment project equal to 0 --Accept the investment whose IRR exceeds the cost of capital (hurdle rate)

Modified IRR (MIRR)

-Rule used to resolve the issue of multiple IRRs

Operating Cash Flow

-The cash flow that results from the implementation of an investment project -Starts with Earnings Before Interest and Taxes (EBIT) and adjust the accounting earning by adding back the Depreciation and deducting taxes -Interest expenses are excluded from the calculation of the OCF

MACRS depreciation schedule

-Accelerated Depreciation -Depreciate To zero -Rationale: more tax shield benefits in the early life; the NPV of tax shields is higher than that of straight-line depreciation

Advantages of NPV rule

-Accounts for the time value of money -Adjusts for risk -Provides an indication of value

Advantages of IRR rule

-Accounts for time value of money -The concept is intuitive and thus, easy to communicate among corporate managers

Conventional cash flows Nonconventional cash flows

-An upfront cost to the project and then, incoming cash flows in future -When the cash flows change sign more than once; consequence..more than one IRR

Discounted payback

-Compute present value of each cash flow, and then determine how long it takes to pay back on discounted basis -Rule is to take an investment if discounted payback is less than a specified time frame ----Accounts for time value of money -Has other issues as with payback rule

Depreciation Tax Shield

-Depreciation is a noncash expense -by deducting depreciation from gross profits and then taking taxes, there will be a tax saving

NPV Rule Zero-NPV projects

-If NPV is positive, accept. Positive project expected to 1. add value to firm and therefore 2. increase wealth of the owners. -Won't add value to the firm. But they do give required rate of return to investors

Net Present Value

-Incremental net value created by undertaking a project -(NPV)the difference between an investment's present value of future profits and its present value of cost

Profitability Index Advantages Disadvantages

-Measures PV per dollar initially invested A: Closely related to NPV, generally leading to identical decisions -Easy to understand and communicate -May be useful when available investment funds are limited D: May lead to incorrect decisions in comparisons of mutually exclusive investments

Why payback method is flawed?

-Primarily because it ignores later year cash flows and the present value of future cash flows

Increase in: 1)Accounts Receivable 2)Inventory 3)Accounts Payable

Cause: 1)NWC to increase, cash flow decrease 2)NWC to increase, cash flow to decrease 3)NWC to increase, cash flow to decrease

Profitability index... The bigger PI is...

PV(CF)/initial capital the bigger NPV is

A project has conventional cash flows (an upfront cost today and a stream of cash flow revenues in future) and a positive NPV. Which of the following statements is true?

The IRR is greater than the required return.

How to determine number of IRRs?

Total number of times that cash flows change signs.

Change In Net Working Capital

adjusts for the discrepancy between accounting earnings and actual cash flows

Less likely to accept project when tax shield after tax salvage value

decreased decreased

Tax Effect if...

if the sale price is different from the book value of the asset

Which one of the following will increase the cash flow from assets, all else equal?

increase in depreciation

According to the Statement of Cash Flows, a decrease in accounts receivable will _____ the cash flow from _____ activities.

increase; operating