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FIN CH 8 UNCW
Terms in this set (34)
analysis of potential projects, long term decisions, large expedentures, difficult/impossible to reverse, determines firms strategic direction
good decision criteria
all cash flows considered? tvm considered? risk adjusted? ability to rank projects? indicates added value to firm?
Net present value
how much value is created from undertaking an investment?
Steps in net present value (NPV)
step 1: estimate the expected future cash flows
step 2: estimate the required return for projects of the risk level
step 3: find the present value of the cash flows and subtract the initial investment to arrive at the NPV
NPV decision rule
if NPV is positive, accept the project. it means project is expected to add value to the firm and will increase the wealth of the owners. NPV is a direct measure of how well this project will meet the goal of increasing shareholders wealth.
Rationale for the NPV method
NPV= PV inflows - cost
npv= net gain in shareholders wealth
meets all desirable criteria- considers all cfs, considers tvm, adjusts for risk, can rank mutually exclusive projects, directly related to increase in Vf, dominant method always prevails
computation= estimate of cash flows, subtract the future cash flows from the initial cost until initial investment is recovered, a break even type measure. decision rule- accept if the payback period is less than some preset limit
advantages & disadvantages of payback
advantages: easy to understand, adjusts for uncertainty of later cash flows, and biased towards liquidity
disadvantages: ignores the time value of money, requires the abritrary cutoff point, ignores cash flows beyond the cutoff date, biased against long term projects, such as research and developmental and new projects
average accounting return
many different definitions for average accounting return(AAR). AAR= avg net income/ avg book value.
requires a target cutoff rate. Decision rule: accept the project if the aar is greater than target rate
advantages and disadvantages of aar
advantages: easy to calculate, needed info usually available.
disadvantages: not a true rate of return, time value of money ignored, uses an arbitrary benchmark cutoff rate, based on accounting net income and book values, not cash flows and market values
internal rate of return
most important alternate to NVP, widely used in practice, intuitively appealing, based entirely on the estimated cash flows, independent of interest rates
Definition & decision rule of IRR
IRR= discount rate that makes the NPV equal to 0
decison rule: accept the project if the IRR is greater than the required return
preffered by executives( intuitively appealing, easy to communicate the value of a project), if the irr is high enough then may not need to estimate a required return, considers all cash flows, considers time value of money, provides indication of risk
can produce multiple answers, cannot rank mutually exclusive projects, reinvestment assumption flawed
NVP vs IRR
they generally give the same decisions.
EXCEPTIONS: non conventional cash flows( cash flow sign changes more than just once), and mutually exclusive projects ( initial investments are substantially different, timing of cash flows is substantially different, and will not reliably rank projects)
IRR & non conventional cash flows
cash flows change sign more than once-most common is initial cost (negative CF), a stream of positive CF's, negative cash flow to close project
independent vs mutually exclusive projects
independent- the cash flows of one project are unaffected by the acceptance of the other
mutually exclusive- the acceptance of one project precludes accepting the other
reinvestment rate assumption
IRR assumes reinvestment at IRR, NPV assumes reinvestment at the firms weighted average cost of capital( opportunity cost of capital- more realistic and npv method is best), and npv should be used to choose between mutually exclusive projects
2 reasons NPV profiles cross
Size(scale) differences- smaller project frees up funds sooner for investment, and the higher the opportunity cost, the more valuable these funs, so high discount rate favors small projects.
timing differences- project with faster payback provides more CF in early years for reinvestment, and if discount rate is high, early CF especially good
conflicts between npv and irr
npv directly measures the increase in value to the firm, whenever there is a conflict between npv and another decision rule always use npv, and IRR is unreliable in the following situations( non conventional cash flows and mutually exclusive projects)
modified IRR- MIRR
controls for some problems with IRR.
1. discounting approach= discount future outflows to present and add to CF 0.
2. reinvestment approach= compound all CFs except the first one and forward to end.
3. combination approach- discount outflows to present, compound inflows to end.
(mirr will be unique number for each method and discount(finance)/ compound(reinvestment) rate externally supplied)
MIRR discounting method
step 1: discount future outflows(neg cash flows) to present and add to CF0
step 2: zero out negative cash flows which have been added to CF0
step 3: compute IRR normally
MIRR reinvestment approach
step 1: compound all cash flows( except cf 0) to end of projects life
step 2: zero out all cash flows which have been added to the last year of the projects life
step 3: compute irr normally
MIRR combnation approach
step 1: discount all outflows(except cfo) to present and add to CF0
step 2: compound all cash inflows to end of projects life
step 3: compute IRR normally
MIRR vs IRR
MIRR correctly assumes reinvestment at opportunity cost = WACC, mirr avoids the multiple irr problem, and managers like rate of return comparisons, and MIRR is better for this than irr
measures the benefit per unit cost, based on time value of money, can be very useful in situations of capital reasoning. Decision rule: if PI > 1.0 then accept
advantages and disadvantages of Prof Index
advantages: closely related to NPV, generally leading to identical decisions( considers all cfs and tvm), esasy to understand and communicate, and useful in capital rationing
disadvantages: may lead to incorrec decisions in comparisons of mutually exclusive investments( can conflict with NPV)
capital budgeting in practice
consider all investment criteria when making decisions, npv and irr are the most commonly used primary investment criteria, payback is a commonly used secondary investment criteria, all provide valuable information
difference between market value( PV of inflows) and cost, accept if npv>0, no serious flaws, and preffered decision criterion
discount rate that makes NPV=0, accept if IRR> required return, same decision as NPV with conventional cash flows, unreliable with non conventional cash flows and mutually exclusive projects, and MIRR= better alternative
length of time until initial investment is recovered, accept if payback < some specified target, doesnt account for time value of money, ignores cash flows after payback, arbitrary cutoff period, and asks the wrong question
average accounting return(AAR) summary
average net income/ average book value, accept if AAR> some specified target, needed data usually readily available, not a true rate of return, time value of money ignored, abritrary benchmark, and based on accounting data not cash flows
profitability index summary
benefit cost ratio, accept investment if PI>1, cannot be used to rank mutually exclusive projects, and may be used to rank projects in the presence of capital rationing