Exam 3

weaknesses of IRR analysis

- does not consider the size of the investment - difficult to calculate. difficult to understand; not intuitive

weaknesses of the payback rule

- does not consider the time value of money - does not consider cash flows after the payback period

which cash flows to use

- incremental cash flows - opportunity costs - externalities (cannibalization, complementary, and environmental) *usually include - shipping and installation or equipment purchases *include in capital expenditures and book value

What is the internal rate of return (IRR)

- it is the rate of return that the company earns on the investment. It is also the rate of return that will result in an NPV of zero. - the company should invest if the IRR is greater than the required rate of return of the company. it should be rejected if it is less than the required return.

problems with IRR

- reinvestment assumptions: IRR assumes that cash flows earned during the project can be reinvested at the same rate as the IRR - Multiple IRR's: if there is more than one negative cash flow during the project, there will be more than one IRR

strengths of the payback rule

- simple and easy to understand - is an indication of liquidity and risk

the payback rule (PB)

- the payback period is the time period required to recoup the initial investment - if the payback period is less than the company's standard then the company could invest

Free Cash Flow (FCF) formula

FCF = [EBIT (1-T) + Depreciation & Amortization] - [Capital expenditures + Change in Net Operating working capital]

abandonment option

The option to shut down a project if operating cash flows turn out to be lower than expected. This option can both raise expected profitability and lower project risk.

True/false The NPV method is preferred over the IRR method because the NPV method's reinvestment rate assumption is better.

True

WACC

Weighted average cost of capital. the weighted average cost of all the sources of a company's capital

Profitability Index (PI)

a measure of the attractiveness of a project or investment. calculated by dividing the present value of future expected cash flows by the initial investment amount in the project.

discounted cash flows (DCF)

a method of valuation used to determine the value of an investment based on its return in the future-called future cash flows. DCF helps to calculate how much an investment is worth today based on the return in the future.

mutually exclusive projects

companies choose a single project on the basis of certain parameters out of the set of the projects where acceptance of one project will lead to rejection of the other project

Independent Projects

projects with cash flows that are not affected by the acceptance or non-acceptance of other projects

market (beta) risk

risk that affects all companies in the stock market *difficult to accurately calculate

discounted payback method

similar to the payback method. the only difference is that you used discounted cash flows. This corrects for the weakness that the PB method doesn't consider the TVM

Discounted Payback Period (DPB)

the length of time it takes the discounted net cash revenue/cost savings of a project to payback the initial investment

Capital budgeting risk: market risk

the project's effect on the firm's beta

Capital budgeting risk: corporate risk

the project's impact on uncertainty about the firms returns

Capital Rationing

the situation that exists if a firm has positive NPV projects but cannot find the necessary financing *they can only choose or invest in a few, not all

Capital budgeting risk: stand-alone risk

the variability of the project's expected returns

Strengths of NPV Analysis

- Answers the question "how will this project affect the value of the company?" - considers time value of money - widely accepted in the financial community

strengths IRR analysis

- answers the question "what return will be made on this investment?" - considers time value of money - easy to understand. everyone understands rate of return.

weaknesses of NPV analysis

- does not consider the absolute value of the investment - assumes that there is no limit for the amount of available capital - difficult to calculate. difficult to understand; not intuitive.

Assuming that a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is CORRECT? a. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive. b. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. c. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. d. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. e. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business.

A. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

Which of the following statements about IRR and NPV is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

C. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

Replacement Chain Approach

For two or more projects with unequal lives, this approach equalize the lives of both options by stacking projects to the least-common life period.

Internal Rate of Return (IRR)

Internal rate of return is a method of calculating an investment's rate of return. The term internal refers to the fact that the calculation excludes external factors, such as the risk-free rate, inflation, the cost of capital, or financial risk.

Net Present Value (NPV)

The best criteria because it provides a direct measure of value the project adds to shareholder wealth. tells us how much an investment is worth throughout its lifetime, discounted to today's value.

payback period (PB)

The length of time required for the stream of cash flows produced by the investment to equal the original cash outlay #of years + ABS(year cash flow covers investment/next years cash flow) **formula is on excel and you know how to do it lol

capital budgeting

The process of planning expenditures on assets with cash flows that are expected to extend beyond one year.

corporate risk

The variability a project contributes to a corporation's stock returns; also called within-firm risk. *difficult to accurately calculate