Finance

Reasons why NPV profiles cross: size (scale) differences: the smaller project frees up funds at t= __ for investment

0

Why are there multiple IRRs? At very ___ discount rates, the PV of both CF1 and CF2 are low so CF0 dominates and again NPV <

0

When trying to find the PV of a CF, how do you find it given the K, year, and CF?

CF/1+k ^n ie: if k is 10% and the cash flow is 10 on the first year.. 10/1.1^1

Why are there multiple IRRs? In between CF1 and CF2, the discount rate hits ___ harder than ___, so the NPV > 0

CF2 harder than CF 1: results: 2 IRRS

What is the problem with IRR?

Doesn't show how you will improve the value of firm. Can be affected by the size of the project

T/F: A basic rule in capital budgeting is that if a project's NPV exceeds in IRR, then the project should be expected

False

The IRR method assumes CFs are reinvested at the ___

IRR

the YTM on the bond would be the ___ of the "bond" project

IRR

this is the discount rate that forces PV of inflows equal to cost and the NPV=O

IRR

IRR is > / < than K?

IRR> K

This is a better measure of IRR, it is the discount rate that causes the PV of a project's terminal value to equal the PV of costs

MIRR

if projects are mutually exclusive, accept the project with the highest ___, those that add the most value

NPV

Between the NPV or IRR method, which is more realistic?

NPV should be used to choose between mutually exclusive projects. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV is the best.

MIRR assumes reinvestment at the _____ ____

Opportunity Cost (WACC)

NPV= ___ of inflows - ____

PV of inflows - Cost Net gain in wealth

What are the three types of project risk?

Project-specific risk, firm risk, and market (or beta) risk

Explain how using a risk-adjusted discount rate improves capital budgeting decision making compared to using a single discount rate for all projectS?

The risk-adjusted discount rate improves capital budgeting decision making compared to the single discount rate approach because RADR allows us to set a higher hurled for the high risk project and a lower hurdle for the low risk project thus aligning our capital budgeting decision making process more closely with the goal of maximizing the value of the firm

t/f: Project S has a pattern of high cash flows in is early life, while project L has a longer life, with large cash flows late in its life. Neither has negative cash flows after year 0, at the current cost of capital, the two projects have identical NPVS. Now, suppose interest rates and money costs decline. Other things held constant, this change will cause L to become preferred to S.

True: With a lower discount rate, all cash flows will be with more, but the large cash flows late in the life of project L will be discounted by much less, this impacting the NPV much more positively than the cash flows of project S

NPV method assumes that CFs are reinvested at the ___

WACC

reject the project if the MIRR < ___

WACC

How do we calculate the payback period for a proposed capital budgeting project? what are the main criticisms of the payback method?

We calculate the payback period for a proposed project by adding a project's positive cash flow, one period at a time, until the sum equals the initial investment. The number of time periods it takes to cover this investment is the payback period. The main criticisms of the payback method are that cash flows after the payback period are ignored and the time value of money is not considered.

Explain how to resolve a "ranking conflict" between the NPV and the internal rate of return. Why should the conflict be resolved as you explained?>

Whenever there is a ranking conflict between NPV and IRR we generally suggest that the project with the highest NPV be chosen. This is because the NPV method ties more directly with the primary financial goal of the firm, to maximize firm value.

if IRR>WACC, accept or reject the project

accept

How do firms adjust for risk in capital budgeting?

adjusting the discount rate used to calculate NPV. Also, the Risk adjusted discount rate (RADR) can also be used as a risk-adjusted hurdle rate for IRR comparisons

NPV generally have ___ decisions

better

capital budgeting is based upon projects riskiness, not just ____ risk

company

how is the TV found when calculating the MIRR?

compounding inflows at WACC

when you increase k, what does this do to the NPV?

decreases it

When comparing the NPV and IRR methods.. if WACC< crossover rate, the methods lead to ___ accept/reject decisions

different

if the WACC is high, ___ CF are especially good.

early

If the IRR>WACC, the project's return ___ its costs and there is some return left over to boost stockholders' returns

exceeds

This type of risk is the most common and calculates the coefficient of variation of returns of the firm's asset portfolio with the project and without it

firm risk

Reasons why the NPV profiles cross: the ___ the opportunity cost, the more valuable these funds, so a ___ WACC favors small project.

higher the opportunity cost, more valuable the project, and a high WACC favors small projects

What are some major weaknesses of payback period method?

ignores the time value of money, ignores CFs occurring after the payback period, does not explicitly consider risk, and choice of acceptable time period is arbitrary

___ discount rate for high risk projects, and ___ discount rate for low-risk projects

increase discount rate for high risk projects, and decrease the discount rate for low-risk projects

These types of projects are if the cash flows of one are unaffected by the acceptance of the other.

independent

Why are there multiple IRRs? At very ___ discount rates, the PV of CF2 is large and negative, so NPV<

low discount rates, NPV<0

This type of risk is the best way if you can find beta, but it is also the hardest way. It is quantifying the effect of the new project on the company's beta

market risk

These types of projects are if the cash flows of one can be adversely impacted by the acceptance of the other

mutually exclusive

Will changing the cost of capital change the IRR?

no

This type of cash flow stream is two or more changes of signs. Most common form (negative CF) then string of positive CFs, then cost to close project. Power plant, strip mine, etc.

non normal cash flow stream

When to use the MIRR instead of the IRR? When there are ___ CFs and more than one IRR, use MIRR

nonnormal

This type of cash flow stream is when the cost (negative CF) followed by a series of positive CFS. One change o signs.

normal cash flow stream

this type of risk is a direct measurement of the project's risk to the firm

project-specific risk

Timing differences: the project with the faster payback period provides ___ CF in early years for reinvestment.

provides more CF in early years for reinvestment

if IRR<WACC, reject or accept the project

reject

What is the NPV?

sum of all the PC's of all cash inflows and outflows of a project

How does the NPV relate to the value of the firm?

the NPV is the dollar amount of the change to the value of the firm if the project under consideration is accepted.

What does MIRR assume cash flows are reinvested at?

the WACC

With drawing NPV profiles, where the cross over happens, what is it?

the discount rate & NPV @ 0

Explain how to measure the firm risk of a capital budgeting project

the firm risk of a capital budgeting project measures the impact of adding a new project to the existing projects of the firm

What is capital rationing?

the practice of placing a dollar limit on the total size of the capital budget. May not be consistent with maximizing shareholder value but may be necessary for other reasons.

When comparing the NPV and IRR methods.. if projects are mutually exclusive: if WACC> crossover rate, the methods lead to the same ___ ___ and there is no conflict

the same decision

How is a project's IRR similar to a bond's YTM?

they are the same thing. think of a bond as a project.

T/F: Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment t time =0, a negative cash flow (or cost) occurs at the end of the project's life

true

T/f: the IRR is that discount rate that equates the present value of the cash outflows (or costs) with the PV of the cash inflows?

true

t/f: Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV

true

t/f: For a project with one initial cash outflow followed by a series of positive cash inflows, the MIRR method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV) and then finding the discount rate that causes the PV of the TV to equal the project's cost

true

t/f: capital budgeting includes long-term decisions and involve large expenditures

true!

when getting CFs sooner rather than later, what does this do to the NPV and why?

you are getting money sooner so the discount on money you get quickly is a lot less than the later years. NPVs>NPV L