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Capital Budgeting traits 5
Analysis of potential projects
Good Decision Criteria
All cash flows considered?
Net Present Value question
How much value is created from undertaking an investment?
net present value
the difference between the cost of an asset and the present value of future cash flows
Net Present Value steps 4
Step 1: Estimate the expected future cash flows.
Net Present Value def
Sum of the PVs of all cash flows
CF0 ,
Net Present Value Initial cost often is what and is an what
CFt/[(1+R)^t]
Net Present Value t=0 calculation
Net Present Value t=1 calculation
sum of all{CFt/[(1+R)^t]} - (CF0)
accept the project
If NPV is positive, what should you do concerning the project
NPV > 0 means whatt 2
Project is expected to add value to the firm,
NPV is a direct measure of what
how well a project will meet the goal of increasing shareholder wealth.
Yes
Can test scores be reliable but not valid?
NPV Method
what is the the Dominant Capital Budgeting method
Payback Period def
How long it takes to recover the initial cost of a project
payback period
the time required for the money saved and/or the income generated by a project or product to equal its initial investment cost; determined as part of life-cycle cost analysis
steps 2
Estimate the cash flows
break-even
what type of measure is Payback Period
Payback Period Decision Rule
Accept if the payback period is less than some presnet limit
Ignores the time value of money
Average Accounting Return calculation
Avg net income/avg book value
Average Accounting Return def
Avg net income/avg book value
a target cutoff rate
Average Accounting Return Requires what
Average Accounting Return Decision Rule
Accept the project if the AAR is greater than target rate.
Average Accounting Return
AAR stands for what
Easy to calculate,
Internal Rate of Return
Most important alternative to NPV
the estimated cash flows
Internal Rate of Return Based entirely on what
interest rates
Internal Rate of Return is Independent of what
IRR stands for what
Internal Rate of Return
Internal Rate of Return def
discount rate that makes the NPV = 0
Internal Rate of Return Decision Rule
Accept the project if the IRR is greater than the required return
IRR calculation steps 3
Enter the cash flows as for NPV
Preferred by executives
Intuitively appealing,
why is IRR Preferred by executives 2
Non-conventional cash flows,
When NVP and IRR won't give the same answer 2
def
Cash flow sign changes more than once
Non-conventional cash flows
Cash flow sign changes more than once
Initial cost (negative CF)
Most common IRR Non-Conventional Cash Flow 3
more than one
IRR Non-Conventional Cash Flows results in how many IRRs
the root of an equation
When you solve for IRR you are solving for what
1
for IRR, how many real roots are there per sign change, and the rest are what
Independent Exclusive Projects
The cash flows of one project are unaffected by the acceptance of the other.
mutually exclusive projects
Projects that, if undertaken, would serve the same purpose. Thus, accepting one will necessarily mean rejecting the others.
IRR
a % rate that equates the present value of the future benefits to the present value of the capital outlays by ownership; measure of investment performance frequently used for acquisition purposes
NPV assumes reinvestment at what
the firm's weighted average cost of capital
opportunity cost of capital,
the firm's weighted average cost of capital
NPV
what should be used to choose between mutually exclusive projects
Size (scale) differences,
Two Reasons NPV Profiles Cross
why do Size (scale) differences cause profiles cross 2
Smaller project frees up funds sooner for investment.
why do Timing differences cause profiles cross 2
Project with faster payback provides more CF in early years for reinvestment.
NPV directly measures the what 2
increase in value to the firm
Discounting Approach
Discount future outflows to present and add to CF0
Reinvestment Approach
Compound all CFs except the first one forward to end
Combination Approach
Discount outflows to present; compound inflows to end
different
will MIRR be the same or different number for each method
externally
MIRR Discount (finance) /compound (reinvestment) rate what supplied
Discounting Approach steps
Step 1: Discount future outflows (negative cash flows) to present and add to CF0
Reinvestment Approach steps 3
Step 1: Compound ALL cash flows (except CF0) to end of project's life
Combination Approach steps 3
Step 1: Discount all outflows (except CF0) to
Opportunity Cost
the value of the best alternative foregone; crucial in world of scarce resources
the multiple
MIRR avoids what IRR problem
Profitability Index
Measures the benefit per unit cost, based on the time value of money
A profitability index of 1.1 implies what
that for every \$1 of investment, we create an additional \$0.10 in value
capital rationing
Profitability Index Can be very useful in situations of what
Profitability Index Decision Rule
If PI > 1.0- Accept
Considers all CFs
how is Profitability Index Closely related to NPV, generally leading to identical decisions 2
May lead to incorrect decisions in comparisons of mutually exclusive investments (can conflict with NPV)
Payback
is a commonly used secondary investment criteria
secondary investment criteria
Payback is a commonly used what
what does NPV measure
\$ increase in VF
Liquidity (Years)
what does Payback measure
what does AAR measure
Acct return (ROA) %
E(R), risk %
what does IRR measure
If rationed Ratio
what does PI measure
NPV Rule
What the managers use, their goal is to maximize NPV
reasons to use NPV
discounts cash flows and therefore determines whether a project Will benefit stockholders
The value of a firm is the sum of the values of the different projects, divisions or other entities within the firm.
payback period method
decides whether to accept or reject a project based on how quickly the initial investment is recovered
arbitrary standards
problems with the payback period method
discounted payback period method
decides whether to accept or reject a project based on how quickly the initial investment is recovered by discounted future cash flows
IRR method
determines a singular number to represent the intrinsic rate of return for the project; the IRR is the rate that causes the NPV to be zero
basic IRR rule
Accept the project if the IRR rate is higher than the discount rate. Reject if it is lower.
independent project
a project whose acceptance or rejection is independent of the acceptance or rejection of other projects
mutually exclusive investments
projects where acceptance of one is dependent on the rejection of the other
problems with IRR
does not take into account financing activities vs investing activities (the rule is opposite when the inflows happen First)
modified IRR
resolves problems with multiple rates of return by consolidating cash flows by discounting them