EXAM 3 FIN.

Why are Capital Budgeting decisions the most important investment decisions made by a firm's management?

Capital budgeting is the process by which management decides which productive assets the firm should invest in. Because capi-tal expenditures involve large amounts o money, are critical to achieving the firm's strategic plan, dene the firm's line of busi-ness over the long term, and determine the firm's profitability for years to come, they are considered the most important invest-ment decisions made by management.

Describe the role of Venture Capitalists in the economy and discuss how they reduce their risk when investing in start-up businesses.

Venture capitalists specialize in helping business firms get started by advising management and providing early-stage financing. Because of the high risk of investing in start-up businesses, ven-ture capitalists finance projects in stages and ofen require the owners to make a signicant personal investment in the firm. Te owners' equity stake signals their belief in the viability of the business and ensures that management actions are focused on building a successful business. Risk is also reduced through syndication and because o the venture capitalist's in-depth knowledge of the industry and technology

Venture capitalists

are individuals or firms that help new businesses get started and provide much of their early-stage financing -Venture capital is important because entrepreneurs have only limited access to traditional sources of funding

angels (or angel investors)

are typically wealthy individuals who invest their own money in emerging businesses at very early stages in small deals

small cap

market capitalization of between $300 million and $2 billion

Large Cap stock Corporation

market capitalization value of more than $10 billion

Why are Capital Budgeting decisions the most important investment decisions made by a firm's management?

· oThese decisions determine the long-term productive assets that will create wealth for a firm's owners · oThe strategic plan spells out strategy for the next 3 to 5 years -•Capital investments are large cash outlays, long-term commitments, not easily reversed, and primary factors in a firm's long-run performance •Capital budgeting techniques help management systematically analyze potential opportunities in order to decide which are worth undertaking

Capital Budget Process

-The capital budgeting process starts with a firm's strategic plan, which spells out its strategy or the next 3 to 5 years. -Division managers then convert the firm's strategic objectives into business plans. These plans have a one- to two-year time horizon, provide a detailed de-scription o what each division should accomplish during the period covered by the plan, and have quantiable targets that each division is expected to achieve. - Behind each division's busi-ness plan is a capital budget that details the resources management believes it needs to get the job done. The capital budget is generally prepared jointly by the CFO's staff and nancial staffs at the divisional and lower levels and reects, in large part, the activities outlined in the divisional business plans. Many of these proposed expenditures are routine in nature, such as the repair or purchase of new equipment at existing acilities. Less requently, rms ace broader strategic decisions, such as whether to launch a new product, build a new plant, enter a new market, or buy a business.

Mutually exclusive projects

-set of projects out of which only one projectcan be selected for investment.oProjects for which the decision to accept one project is simultaneously a decision to reject another project oThese projects typically perform the same function

There are three primary reasons why traditional sources of funding do not work for new or emerging businesses

1. There is a high degree of risk involved in starting a new business 2.Types of productive assets: new firms whose primary assets are often intangible (patents or trade secrets) find it difficult to secure financing from traditional lending sources 3. Information asymmetry problems: an entrepreneur knows more about his or her company's prospects than a lender does

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1.Small cap investors may struggle to offload shares. When there is less liquidity in a marketplace, an investor may find it takes longer to buy or sell a particular holding with little daily trading volume. 2.The managers of small-cap funds close their funds to new investors at lower assets under management (AUM) thresholds.

fixed asset

A fixed asset is a long-term tangible piece of property or equipment that a firm owns and uses in its operations to generate income. Fixed assets are not expected to be consumed or converted into cash within a year. Fixed assets most commonly appear on the balance sheet as property, plant, and equipment(PP&E). They are also referred to as capital assets. -A company's balance sheetstatement consists of its assets, liabilities, and shareholders' equity. Assets are divided into current assetsand noncurrent assets, the difference for which lies in their useful lives. Current assets are typically liquid assets which will be converted into cash in less than a year. Noncurrent assets refer to assets and property owned by a business which are not easily converted to cash. The different categories of noncurrent assets include fixed assets, intangible assets, long-term investments, and deferred charges.

short term loan

A loan scheduled to be repaid in less than a year. When your business doesn't qualify for a line of credit from a bank, you might still have success in obtaining money from then in the form of a one-time, short-term loan (less than a year) to finance your temporary working capital needs.

fixed assets key takeaways

Fixed assets are items, such as property or equipment, a company plans to use over the long-term to help generate income. Fixed assets are most commonly referred to as property, plant, and equipment (PP&E). Current assets, such as inventory, are expected to be converted to cash or used wterm-33ithin a year. Noncurrent assets besides fixed assets include intangibles and long-term investments. Fixed assets are subject to depreciation to help represent the lost value as the assets are used, while intangibles are amortized.

Advantages of borrowing from a commercial bank rather than selling securities in financial markets and discuss bank term loans.

Most small- and medium-size firms borrow from commercial banks on a regular basis. Small- and medium-size firms may have limited access to the financial markets. For these firms, banks provide not only funds but a full range of services, including financial advice. Furthermore, if a firm's financial circumstances change over time, it is much easier for the firm to borrow or re-negotiate the debt contract with a bank than with other lenders. For many companies, bank borrowing may be the lowest-cost source of funds.Bank term loans are business loans with maturities greater than one year. Most bank term loans have maturities from one to five years, though the maturity may be as long as fifteen years. The cost of the loans depends on three factors: the prime rate, an adjustment for default risk, and an adjustment for the term to maturity.

Contingent projects

Projects for which the decision to accept one project depends on acceptance of another project

Independent projects

Projects for which the decision to accept or reject is not influenced by decisions about other projects being considered by the firm

Opportunity Cost of capital

The opportunity cost of capital is the incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing cash in a marketable security. Thus, if the projected return on the internal project is less than the expected rate of return on a marketable security, one would not invest in the internal project, assuming that this is the only basis for the decision. The opportunity cost of capital is the difference between the returns on the two projects.

Describe the strengths of the payback period as a capital expenditure decision making tool

The payback period is the length of time it will take for the cash flows from a project to recover the cost of the project. Te payback period is widely used, mainly because it is simple to apply and easy to understand. It also provides a simple mea-sure of liquidity risk because it tells management how quickly the firm will get its money back.

Capital rationing

a firm with limited funds chooses the best projects to undertake

Describe the weaknesses of the payback period as a capital expenditure decision making tool

ignores the time value of money. We can overcome this objection by using discounted cash flows to calculate the payback period. It fails to take ac-count of cash flows recovered after the payback period. Thus, the payback period is biased in favor of short-lived projects. Also, the hurdle rate used to identify what payback period is acceptable is arbitrarily determined.

Abundance of caution

is a credit issue that affects when an appraisal is required and then affects some other regulatory situations. ... An institution may take a lien on real estate and be exempt from obtaining an appraisal if the lien on real estate is taken by the lender in an abundance of caution.

compensating balances

is a minimum balance that must be maintained in a bank account, used to offset the cost incurred by a bank to set up a loan. The compensating balance is not available for company use, and may need to be disclosed in the borrower's notes to the financial statements.

The Payback Period

is the amount of time it takes for the sum of the net cash flows from a project to equal the project's initial investment oThe project is acceptable if the payback period is shorter than a certain amount of time oCan serve as a risk indicator: the quicker a project's cost is recovered, the less risky the project oPayback Period is one of the most widely used tools for evaluating capital projects •Projects with shorter payback periods are more desirable

Venture Capital Funding Cycle

look at slides

payback period

number of years it takes for the cash fows from a project to recover the project's initial investment. With the payback method for evaluating projects,a project is accepted if its payback period is below some specifed threshold. Although it has serious weaknesses, this method does provide some insight into a project's risk; the more quickly you recover the cash, the less risky is the project.

Explain the benefits of periodic review of capital projects.

oA periodic review should challenge the business plan, including cash flow projections, cost assumptions, and the performance of people responsible for implementing the capital project

Explain the benefits of post-audit of capital projects.

oA post-audit examination may reveal why a project was successful or failed to achieve its financial goals

•Practical difficulties in valuing real assets

oCash flow estimates must be prepared in-house and are not as readily available as those for financial assets with legal contracts oEstimating required-rates-of-return for real assets is more difficult than estimating required return for financial assets because no market data is available

Valuing real assets

oEstimate future cash flows oEstimate cost of capital/required-rate-of return Calculate present value of future cash flows

Bank term loans

oTerm loans are business loans with maturities greater than one year oMay be secured or unsecured, and the funds can be used to buy inventory or to finance plant and equipment

Capital Budgeting

process of choosing the roductive assets in which the rm will inves Capital budgeting decisions are the most important investment decisions made by manage-ment. The objective o these decisions is to select investments in productive assets that will increase the value o the rm. Tese investments create value when they are worth more than they cost. Capital investments are important because they can involve substantial cash outlays and, once made, are not easily reversed. Tey also dene what the company is all about—the rm's lines o business and its inherent business risk. For better or worse, capital investments produce most o a typical rm's revenues or years to come. Capital budgeting techniques help management systematically analyze potential business opportunities in order to decide which are worth undertaking. As you will see, not all capital budgeting techniques are equal. Te best techniques are those that determine the value o a capital project by discounting all o the cash ows generated by the project and thus account or the time value o money. We ocus on these techniques in this chapter. In the nal analysis, capital budgeting is really about management's search for the best successul firms are those whose managements consistently search for and find capital invest-ment opportunities that increase firm value.

volatility

range of price change a security experiences over a given period of time. If the price stays relatively stable, the security has low volatility

Cost of capital

rate of return that a project must earn to be accepted by management

Initial Public Offering

selling common stock in an initial public offering