FINA 3133 Final Exam

Profitability Index (PI) Formula

PV of benefits / PV of costs

step 3 in capital budgeting

Decision making

What types of projects does BNSF strategic studies team evaluate?

Discretionary

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

False

The financing decision

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

the dividend decision

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

step 4 in capital budgeting

Implementation

The primary purpose of capital budgeting is to

Maximize the shareholders' wealth

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

Average Accounting Return (ARR) Formula

Net Income p.a. / Book Value p.a.

John Stevens, BNSF Vice President and Controller describes the capital spending process primarily as

a means to ensure regulatory compliance a balancing act that requires careful evaluation of the costs and benefits of each project

Profitability Index (PI)

alternatively referred to as value investment ratio (VIR) or profit investment ratio (PIR), describes an index that represents the relationship between the costs and benefits of a proposed project. It is calculated as the ratio between the present value of future expected cash flows and the initial amount invested in the project. A higher PI means that a project will be considered more attractive.

A 20% reduction in forecast sales would not extinguish a project's profitability, then sensitivity analysis would suggesst:

deemphasizing that variable as a critical factor.

step 5 in capital budgeting

follow-up

throwing good money after bad - how can banks limit losses from bad loans?

increase bank executive turnover

The investment decision

invest in assets that earn a return greater than the minimum acceptable hurdle rate

Internal Rate of Return (IRR)

is a metric used in financial analysis to estimate the profitability of potential investments. It is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.

Mutually Exlusive

is a statistical term describing two or more events that cannot happen simultaneously. It is commonly used to describe a situation where the occurrence of one outcome supersedes the other.

Net Present Value (NPV)

is the difference between the present value of cash inflows and the present value of cash outflows over a period of time. It is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project.

Capital rationing may be beneficial to a firm if it:

weeds out proposals with weaker or biased NPV's

Disadvantages of the IRR period method is that it

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

Disadvantages of IRR

- Requires complex calculations - Requires a lot of data (estimates of all CFs) - Only works for normal cash flows - Requires discount rate (for decision) - Does not always work for mutually exclusive projects

Identify which of these are the relevant cash flows when considering a capital budgeting project

- lost rent from retail facility - remodeling expenses for new store - increase in inventory - expected salvage value of manufacturing equipment

What types of analysis do the BNSF strategic studies team conduct?

- Discounted cash flow - Sensitivity

What are advantages of payback period?

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

Advantages of IRR

- More intuitive than NPV - Gives a clear accept/reject decision for independent projects - Uses all Cash flows - Does not require a discount rate (for calculation) - Adjusts for TVM and therefore risk (in comparing to hurdle rate that adjusts for risk)

Which of the following changes, if of a sufficient magnitude, could turn a negative NPV project into a positive NPV project?

A decrease in the fixed costs

A corporation is contemplating an expansion project. The CFO plans to calculate the project's NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the corporation's cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows?

Any opportunity costs associated with the project.

step 1 in capital budgeting

Proposal generation

step 2 in capital budgeting

Review and analysis

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

The cost of capital exceeds the IRR

The Initial Rate of Return is the discount rate that equates the NPV of an investment opportunity with $0

True

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

True

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

True

Payback Period

refers to the amount of time it takes to recover the cost of an investment. Simply put, the it is the length of time an investment reaches a break-even point.