finance exam 3 ch.8,9,&13

multiple IRR problem

non-normal cash flow patterns have more than one IRR because they change directions more than once. Cannot use IRR

risk and present value

*higher risk projects have a rate of return *higher required rate of returns cause lower PV's

net present value rule

*managers increase shareholder's wealth by accepting projects that are worth more than they cost -therefore they should accept all projects with a positive NPV

total cash flows =

+ cash flows from capital investments + cash flows from changes in working capitals +operating cash flows

operating cash flow =

+ revenue -costs -taxes

can flows from changes in working capital

-Investments in working capital represents a negative cash flow (inventories, account receivable) -when inventories are sold off and account receivables are collected, the firm converts these assets to positive cash flow.

Weighted Average Cost of Capital (WACC)

-company cost of capital = Weighted average of debt and equity returns -The expected rate of return on a portfolio of all the firm's securities, adjusted for tax savings du to interest payments *use market values not book values

disadvantages of payback rule

-takes no account of cash flows after the acceptable payback period -ignore time value of future cash flows has to decide of appropriate cutoff period

Interpreting WACC

-the right discount rate for average risk capital investments of firm -the return the company needs to earn after tax in order to satisfy all its security holders

three steps to calculate cost of capital

1. calculate the value of each security as a proportion of the firm's market value -debt -preferred stock -common stock 2. determine the required rate of return for each security 3. calculate a weighted average of the after-tax return on the debt and the return on the equity

Selecting the projects with the highest NPV(s) is not the correct decision rule when there is:

Capital rationing- use highest PI with capital rationing

r preferred =

DIV1/ Po (no growth)

For mutually exclusive projects, the projects with the higher IRR os the correct decision (t/F)

False, use Irr for indecent or normal projects, for mutually exclusive have to use higher NPV

an increase in a firm's debt ratio will have no effect on the required rate of return for equity holders (t/f)

False- effects everything

Projects with an NPV of zero decrease shareholders' wealth by the cost of the project. (T/F)

False- not by the cost of the project but by the cost of the NPV. *managers increase shareholder's wealth by accepting projects that are worth more than they cost

rate of return rule

Invest on any project offering an IRR that is higher than the opportunity cost of capital

nvp is negative when...

Irr<discount rate

According to the NPV rule, all projects should be accepted if NPV is positive when discounted at the...

Opportunity cost of capital

The Internal Rate of Return (IRR) represents which of the following:

The discount rate that makes the net present value equal to zero.

r debt =

YTM on bonds

Which one of the following changes will increase the NPV of a project?

a decrease in the discount rate

normal project vs non-normal project

normal: cash flows change direction one time (rely on IRR) non-normal: cash flows don't change direction at all or change direction more than once (rely on NPV)

nvp > 0

accept

irr > 0

accept * only rely on Irr if the project is normal

independent projects

acceptance or rejection has no effect on other projects

capital structure decisions refers to:

blend of equity and debt used by the firm

net present value

present value of cash flows minus initial investments

market value of bonds

pv of all coupons and face value discounted at the current YTM

when you need to decide between mutually exclusive projects, the decision rule is...

calculate nvp for each, then chose the one with the highest nvp

incremental cash flow

cash flow with project - cash flow without project

profitability index (PI)

ratio of nvp / initial investments *invest if Profitability index > 0 *ONLY US PI WHEN THERE IS CAPITAL RATIONING, INVEST IN ONES THT HAVE HIGHEST PI

internal rate of return (IRR)

discount rate at which NPV = 0

r equity

div1/Po + g (constant growth)

A project requires an initial outlay of 10 million. If the cost of capital exceeds the projects IRR, then the project has a(n)...

negative NPV NPV< 0 = IRR < R

A firm is considering expanding its current operations and has estimated the internal rate of return on that expansion to be 12.2%. The firm's WACC is 11.8%. Given this, you know that the:

expansion should be undertaken as it has a positive net present value.

opportunity cost of capital

expected rate of return given up by investing in a project

A firm's cost of capital should be used as the discount rate for every new project the firm considers. (t/f)

false- can't be used for all projects just difficult ones

The rationale for not including sunk costs in capital budgeting decisions is that they:

have no incremental effect on project cash flows.

payback period formula

initial investment / annual cash flow

nvp is positive when...

irr> discount rate (r)

capital rationing

limiting the number of capital expenditure projects due to -insufficient funds to finance all projects that meet the firms acceptability rate -lack of sufficient managerial resources to undertake all otherwise acceptable projects

market value of equity

market price per share multiples by the number of outstanding shares

v =

market value of debt + market value of preferred stocks +market value of common stocks D+P+E

If the IRR for a project is 15%, then the project's NPV would be:

negative at a discount rate of 20%.

cost of capital

the return the firm's investors could expect to earn if they invested in securities with comparable degrees of risk

payback period (& for uneven)

time until cash flows recover the initial investments of the project uneven cashflows: add annual CF's to find the # of years it takes to reach initial investment

If the firm increases its debt ratio, both debt and the equity will become riskier, debt holders and equity holders require a higher return to compensate for increased risk

true

The company cost of capital is the expected rate of return that investors demand from the company's assets and operations. (t/f)

true

There are two costs of debt finance. The explicit cost of debt is the rate of interest that bondholders demand. But there is also an implicit cost, because higher levels of debt increase the required rate of return to equity.

true

As the opportunity cost of capital decreases, the NPV of a project increases (t/F)

true - because if the Opp. Cost/cap. decreases that means the IRR is higher and if IRR is higher that means NPV is positive and likely increasing

mutually exclusive projects

two or more projects of which only one may be accepted. The best of the mutually exclusive projects is accepted, and the others are rejected

What decision should be made on a project with above-average market risk?

use a higher discount rate than the WACC to reflect the project's risk and accept if NPV is positive at this higher discount rate.

To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's:

weighted average cost of capital

To calculate the present value of a business, the firm's free cash flows should be discounted at the firm's:

weighted-average cost of capital.