Fina 3313
Disadvantages of NPV
-requires complex calculations -requires a lot of data(estimates of all CFs and r) Dollar value is not always intuitive
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) -doesn't always work for mutually exclusive projects
The payback period is mainly useful when:
1) When there's not enough data available to accurately estimate NPV 2) For communication to a less sophisticated audience 3) When concerns about liquidity are very important 4) When comparing mutually exclusive projects that have the same NPV, the payback period could be a useful secondary method to choose between projects
Project
A general term for any long-term activity that a firm does that requires a cost and generates cash flows. Projects usually involve the purchase of long-term fixed assets
Capital Budgeting Process (step 3)
Decision making, firms typically delegate capital expenditure decision making on the basis of dollar limits
Capital Budgeting Process (step 5)
Follow up, results are monitored and actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones
Fractional amount of last year to calculate payback period
Fractional amount of last year= additional CF in next year to break even/ total cash flow in next year
MACRS Depreciation
Lists different depreciation percentages for each year for different types of assets. MACRS depreciation expense for year i= (initial cost)(MACRS percentage for year i)
Sensitivity Analysis
Look specifically at how NPV changes when we change one of the variables that we input into our NPV calculations. An NPV profile is an example of a sensitivity analysis where we examine the NPV for different discount rates
Net Working Capital (NWC)
Net working capital is a measure of a companies liquidity operation of efficiency and its short-term financial health. If a company has a substantial positive working capital, then it should have the potential to invest and grow. If a company's current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors or even go bankrupt
Opportunity Costs
Opportunity cost represent the potential benefits of an individual, investor, or business misses out on when choosing one alternative over another. Reflect alternative projects and do represent incremental CFs.
Profitability Index (PI) Formula
PI= PV of benefits/ PV of costs PI= NPV+CFo / CFo (CFo is enetered as a positive value)
Payback Period Formula
Payback period= # of whole years + (additional CF needed in next year to break even/ total cash flow in next year)
Multiple IRR Problem
Problem occurs when the signs of a project's cash flows change more than once. An example of a second sign change would be when a project has a negative value for CFo, then some positive cash flows, and then one or more negative cash flows during later periods. MESSY. Mathematically there will be more than one discount rate that yields an NPV equal to zero (IRR)
IRR formula
NPV=0= CFo + CF1/1+r + CF2/(1+r)^2.....
NWC
NWC= CA- CL (Net working capital= current assets- current liabilities)
Discounted Payback Period
Adjusting for this by computing the payback period using the present value of all cash flows (not widely used)
After tax salvage value
After tax salvage value = salvage value- T(salvage value-book value)
Scenario Analysis
Concerns what happens to a firm's NPV in different possible outcomes
Payback Period
Expresses the value of a project in terms of how much time it takes to break even or to recover the initial cost of a project. Can be thought of a measure of the liquidity of a project.
Internal Rate of Return (IRR)
Expresses the value of the project as a rate of return
NPV assumes intermediate cash flows are invested at the cost of equity, while IRR assumes that they are reinvested at the cost of capital. True or False
FALSE, NPV assumes intermediate cash flows are invested at the cost of capital, while IRR assumes that they are reinvested at the IRR rate
As for the decision criteria of IRR, if the IRR is less than the cost of capital, accept the project. True of False
False
Capital Budgeting Process (step 1)
Proposal generation, proposals for new investment projects are made at all levels within business organization and are reviewed by finance personnel
Sunk Costs
Refer to any cash flows that have already been incurred or that will still be incurred even if a project is rejected.p and cannot be recovered. Sunk costs are not incremental cash flows and should not be included.
Capital Budgeting Process (step 2)
Review and analysis, financial managers perform formal review and analysis to assess the merits of investment proposals
Capital Rationing
Situation where the amount of money available to spend is limited and so several projects must be ranked and compared
Straight line depreciation
Straight line basis= (initial cost- salvage value) / number of years or useful life
Tax Shield Approach
Tax shield approach= (revenues-expenses)(1-T) + T(depreciation)
Operating cash inflows
The incremental after-tax cash inflows resulting from the implementation of a project during its life
Crossover rate
The point where there will be a rate where the NPV of both projects is equal also known as crossover point. The crossover rate can be identified on the NPV profile and it can be computed precisely by computing the IRR of the difference in the cash flows of the 2 projects
mutually exclusive projects
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. Accept the project with the highest NPV
Capital Budgeting
The process of evaluating and choosing capital projects
Initial investment
The relevant cash outflow for a proposed project at time zero
Cumulative net CF
The sum of all the cash flows that have occurred up until a certain point in time
If the discount rate is less than the IRR then...
the NPV will be positive
Book Value
Book value= initial cost- accumulated depreciation
Disadvantages of Payback Period
- does not measure value - does not fully adjust for TVM - does not fully adjust for risk - no clear accept/ rejection decision - ignores later CFs
Advantages of Payback Period
- measures liquidity - easy to communicate - does not require all CFs - does not require discount rate - does not require complex calculations - can be used to compare mutually exclusive projects
Advantages of NPV
-gives a clear accept/ reject decision -uses all cash flows -adjusts for risk (with discount rate) -adjusts for TVM
Advantages of IRR
-more intuitive than NPV gives a clear accept/ reject decision for independent projects -uses all cash flows -does'nt require a discount rate (for calculation) -adjusts for TVM and therefore risk (in comparing to hurdle rate that adjusts to risk)
NPV Profile
A graph that shows a project's NPV for different discount rates; Discount rate on the X axis, NPV on the Y; IRR is where the line intersects the X axis
Pro- forma
A pro forma income statement is just an estimated or forecasted income statement used to estimate the operating cash flows
Decision rule for the IRR that's consistent with the NPV rule:
A project should be accepted if its IRR is greater than the discount rate; A project should be rejected if the IRR is less than the discount rate
What are the advantages of NPV? A) Gives a clear accept/reject decision B) Uses all cash flows C) Adjusts for risk (with discount rate) D) Adjusts for TVM E) Requires complex calculations
A) Gives a clear accept/reject decision B) Uses all cash flows C) Adjusts for risk (with discount rate) D) Adjusts for TVM
Consider a project with an initial investment and positive future cash flows. As the discount rate decreases, the A) IRR remains constant while NPV increases B) IRR remains constant while NPV decreases C) IRR decreases while NPV remains constant D) IRR increases while NPV remains constant E) IRR increases while NPV decreases F)IRR decreases while NPV increases
A) IRR remains constant while NPV increases
What are the decisions criteria of NPV? A) If the NPV is greater than $0, accept the project. B) If the NPV is greater than $0, reject the project. C) If the NPV is less than $0, reject the project. D) If the NPV is less than $0, accept the project.
A) If the NPV is greater than $0, accept the project. C) If the NPV is less than $0, reject the project.
Which of the following statements is correct? A) If the PI of a project is less than 1, its NPV should be less than 0. B) If the IRR of a project is greater than the discount rate, k, its PI will be less than 1 and it's NPV will be greater than 0. C) If the IRR of a project is 0%, its NPV, using a discount rate, k, greater than 0, will be 0. D) If the NPV of a project is greater than 0, its PI will equal 0.
A) If the PI of a project is less than 1, its NPV should be less than 0.
What are advantages of payback period? A) Measures liquidity, easy to communicate B) Does not require all CFs, does not fully adjust for TVM C) Does not require discount rate D) Does not require complex calculations
A) Measures liquidity, easy to communicate C) Does not require discount rate D) Does not require complex calculations
The "gold standard" of investment criteria refers to: A)NPV B)EVA C)profitability index D)IRR E)payback period
A) NPV
The disadvantages of the IRR period method is that it A) Requires complex calculations B) Requires a lot of data (estimates of all CFs) C) Only works for normal cash flows D) Does not require a discount rate (for calculation) E) Adjusts for TVM and therefore risk (in comparing to hurdle rate that adjusts for risk)
A) Requires complex calculations B) Requires a lot of data (estimates of all CFs) C) Only works for normal cash flows
A profitability index of .95 for a project means that: A) The project returns 95 cents in present value for each current dollar invested B) The payback period is less than one year C) The project's NPV is greater than zero D) The present value of benefits is 85% greater than the project's costs
A) The project returns 95 cents in present value for each current dollar invested
Relevant Cash Flows
Are only the costs that will be affected by the specific management decision being considered. Relevant cash flows are incremental meaning they are project specific and are only incurred when a project is undertaken. Relevant cash flows include opportunity cost but not sunk costs.
Independent Projects
Are ones where the acceptance of the project does not constrain the firm from engaging in any other projects. The goal for independent projects is to accept all projects where the benefits exceed the costs. Should be a accepted if its NPV is positive!
If a 20% reduction in forecast sales would not extinguish a project profitability, then sensitivity analysis would suggest: A) That the initial sales forecasts were inflated B) Deemphasizing that variable as a critical factor C) requiring a more detailed sales forecast D) reallocating fixed cost to this product
B) Deemphasizing that variable as a critical factor
Which of the following statements is correct for a project with a negative NPV? A) Accepting the project has an indeterminate affect on shareholders B) The cost of capital exceeds the IRR C) IRR exceeds the cost of capital D) The discount rate exceeds the cost of capital
B) The cost of capital exceeds the IRR
Projects that compete with one another so that the acceptance of one eliminates from further consideration of all other projects that serve a similar function. A) dependent B) mutually exclusive C) mutually inclusive D) independent
B) mutually exclusive
A corporation is contemplating an expansion project. CFO plans to calculate the project's NPV by discounting the relevant cash flows (which include the initial upfront costs, the operating cash flows, and the terminal cash flows) at the corporations cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows? A) any sunk costs associated with the project B) any interest expenses associated with the project C) any opportunity costs associated with the project D) all past costs associated with the original project
C) any opportunity costs associated with the project
According to the article, "Sunk Cost Fallacy: Throwing good money after bad," how can banks limit losses from bad loans? A) reduce provisions for non-performing loans B) make fewer loans to businesses C) increase bank executive turnover
C) increase bank executive turnover
Identify which of these are the relevant cash flows when considering a capital budgeting project: A) test marketing costs B) fraction of CEO salary C) lost rent from retail facility D) remodeling expenses for new store E) increase in inventory F) expected salvage value of manufacturing equipment
C) lost rent from retail facility D) remodeling expenses for new store E) increase in inventory F) expected salvage value of manufacturing equipment
What is the NPV of a project that costs $100,000 and returns $50,000 annually for three years if the opportunity cost of capital is 6.4%?
CFO=-100,000 CO1=50,000 FO1=3 I=6.4% CPT NPV= $32,667.62
What is the internal rate of return (IRR) for a project with an initial outlay of $10,000 that's expected to generate cash flows of $2,000 per year for 6 years?
CFo=-10,000 CO1=2,000 FO1=6 CPT IRR= 5.47
Your firm has a potential project that will cost $5000 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. What is the IRR? If the discount rate is 8% then should the firm accept or reject the project?
CFo=-5,000 CO1=900 FO1=3 CO2=1,400 FO2=3 CPT IRR= 9.09 With the discount rate of 8%, we would accept bc the IRR is greater than the discount rate. If the discount rate had been greater than the IRR then we would have rejected.
The primary purpose of capital budgeting is to: A) maximize the firms profit B) minimize the firms costs C) maximize the budget D) maximize the shareholders wealth
D) maximize the shareholders wealth
Capital Rationing may be beneficial to a firm if it: A) allows managers to select their favorite projects B) increases funds to be used for other purposes C) reduces a firm's interest expense D) weeds out proposals with weaker and biased NPVs
D) weeds out proposals with weaker and biased in NPVs
Which of the following changes, if of a sufficient magnitude, could turn a negative NPV project into a positive NPV project? A) A decrease in the estimated annual sales B) an increase in the discount rate C) an increase in the initial investment D) A decrease in the fixed costs
D. A decrease in the fixed costs
Capital spending
Generally represents spending on fixed assets for a project. Most of the time this is the initial cost as well as any salvage value at the end of the project.
Capital Budgeting Process (step 4)
Implementation, following approval expenditures are made and projects implemented. Expenditures for large projects often occur in phases
Your firm has a potential project that will cost $5000 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 NPV? Should the firm accept or reject the project.
Solution: CFo= -5000, CO1= 900, FO1= 3, CO2=1400 FO2=3, I=8 CPT NPV= $183.48 The NPV is positive so we accept the project
Terminal cash flow
The after-tax non-operating cash flow occurring in the final year of a project. It is usually attributable to the liquidation of the project.
Net Present Value (NPV)
The primary method of capital budgeting, generates a dollar figure for the overall value of a project
Profitability Index (PI)
describes an index that represent the relationship between costs and benefits of a proposed project. (Attractiveness) = 1: minimum acceptable number, investment breaks even <1: undesirable, not profitable bc it costs more than it will earn REJECT PROJECT >1: most desirable, alien of the future cash is greater than the initial investment= profitable ACCEPT PROJECT
Internal Rate of Return (IRR)
the discount rate that results in an NPV of zero for a project. "Return on a project"
Capital Expenditures (CAPEX)
the money used by a company to improve long-term physical assets such as property, buildings, or equipment.
Depreciation Tax Shield
the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate (T) Depreciation tax shield= T(depreciation expense)
The PI is only useful if...
the value of a project needs to be communicated as a ratio instead of as a dollar amount. The PI can be thought of as measuring how much NPV a project will generate per dollar spent
Because the IRR represents the discount rate that gives an NPV of zero, if the discount rate is greater than the IRR...
then the NPV will be less than zero.