Module 5: Ch 9.1-9.8 Capital Budgeting

The financing decision

Financing Decision: Find the right kind of debt for your firm and the right mix of debt and equity to fund your operations

What is the internal rate of return for a project with an initial outlay of $10,000 that is expected to generate cash flows of $2,000 per year for 6 years?

IRR: CFO = -10,000 CO1 = 2,000 FO1 = 1*6 = 6 CPT IRR = 5.47

Capital rationing may be beneficial to a firm if it:

weeds out proposals with weaker or biased NPVs.

The investment decision

Investment Decision: Invest in assets that earn a return greater than the minimum acceptable hurdle rate

The investment decision The financing decision The dividend decision

Investment Decision: Invest in assets that earn a return greater than the minimum acceptable hurdle rate

The primary purpose of capital budgeting is to ..

Maximize the shareholder's wealth

In contrast, if a firm may accept only one project from a particular menu of options and must reject all alternatives then projects are said to be...?

Mutually Exclusive

Projects that compete with one another so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

Mutually Exclusive

The "gold standard" of investment criteria refers to:

NPV

The multiple IRR problem occurs when the signs of a project's cash flows change more than once.

True

You are considering the following three mutually exclusive projects. The required rate of return for all three projects is 14%. Year A B C 0 $ (1,000) $(5,000) $(50,000) 1 $ 300 $ 1,700 $ 0 2 $300 $ 1,700 $15,000 3 $ 600 $1,700 $ 28,500 4 $300 $1,700 $ 33,000 What is the IRR of the best project? % terms to 2 decimal places w/o % sign

Want to choose the closest range to 14%, 14.23% IRR (14.2286002)

Step 1 Proposal generation Step 2 Review and analysis Step 3 Decision making Step 4 Implementation Step 5 Follow-up

What are the capital budgeting steps?

Disadvantages of Payback period

Wrong values lead to bad results and end up rejecting it. causing to ignore and the payback period

Compute the payback period for a project that requires an initial outlay of $132,995 that is expected to generate $40,000 per year for 9 years.

Year 0 -132,995, -132,995 Year 1 +40,000, -132,995 +40,000 Year 2 +40,000, -92,995 + 40,000 Year 3 +40,000, -52,995 + 40,000 Year 4 +40,000, -12,995 + 40,000, STOP (-12,995) Year 5-9 +40,000 VV Break even Year - 1 + (Payment/Year) = (4-1) + (12995/40,000) = 3 + .3248750 = 3.3248 =3.32*

If a project's cash flow are not well-balanced then we can encounter a situation known as the multiple IRR Problem

Yes, if it occurs. Multiple IRR problems

The Internal Rate of Return (IRR) is the discount rate that equates the NPV of an investment opportunity with $0

True

Payback Period is useful when..

1) When there is not enough data available to accurate NPV 2) For communication to a less sophisticated audience 3) Concern about liquidity are very important 4) Comparing NPV w/ Similar % Payback

What is the NPV of a project that costs $100,000.00 and returns $50,000.00 annually for three years if the opportunity cost of capital is 8.94%?

CFO = -1000 CO1 = 50,000 FO1 = 1*3 = 3 I = 8.94% NPV = ? CPT NPV = 26700.2

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $900 at the end of the next three years and then $1400 per year for the three years after that. If the discount rate is 8% then what is the PI? Answer in % format with 2 number after the decimal point

CFO = -5,000 CO1 = 900 FO1 = 3 CO2 = 1400 I = 8% CPT NPV = 183.4830359 (183.4830 +5,000)/ 5000 103.67 % Steps: CFO = Potential CO1 = After tax FO1 = x year CFO2 = AFT FO2 = x years I = x% CPT NPV = NPV NPV + CFO ------------------ CFO = PI in %

What is the profitability index for Project A with a cost of capital of 8%? Year 0 Project A($42,000.00)Project B ($45,000.00) $14,000.00$28,000.002$14,000.00$12,000.003$14,000.00$10,000.004$14,000.00$10,000.005$14,000.00$10,000.00

Calculate PI: CFO = -42,000 Step 1 CO1 = 14,000 FO1 = 5 I = 8% CPT NPV = 13897.94052 Step 2 - Compare Step 3 Pick Project A and find PI use PI = (NPV + CFO)/CFO = (13897.99052+42000)/42000 = 1.33

Your firm has a potential project that will cost $5,000 now to begin. The project will then generate after-tax cash flows of $144 at the end of the next three years and then $1,897 per year for the three years after that. If the discount rate is 9.11% then what is the NPV?

Compute NPV: CFO = potential project -5000 After Tax = 144 FO1 = x year = 1*3 = 3 CO2 = After tax = 1897 FO2 = x years = 1*3 = 3 I = 9.11 CPT NPV = 946.7237996

The dividend decision

Dividend Decision: If you can't find investments that makes your minimum acceptable rate, return the cash to owners of your business

What are advantages of payback period?

Does not require discount rate Measures Liquidity, Easy to communicate Does not require complex calculations

It should not usually be clear whether we are describing independent or mutually exclusive projects in the following chapters because when we only describe one project then it can be assumed to be independent

False

NPV assumes intermediate cash flows are reinvested at the cost of equity, while IRR assumes that they are reinvested at the cost of capital

False

Net present value (NPV) is a sophisticated capital budgeting technique; found by adding a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital.

False

The disadvantages of the IRR period method is that it

Only works for normal cash flows Requires a lot of data (estimates of all CFs) Requires complex calculations

Expresses the value of a project in terms of how much it akes to break even or to recover initial cost of a project.

Payback period

Advantages of Payback Period

Payback period is easier to explain and show people who have no knowledge in finance. An easier calculation to show and stuff NO, TVM or estimates of CashFlow

Which of the following statements is correct for a project with a negative NPV?

The cost of capital exceeds the IRR

Compute the payback period for a project that requires an initial outlay of $138,098 that is expected to generate $40,000 per year for 9 years.

initial outlay/expected CF = 138,098/40,000 = 3.45 Ye