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Business Finance Exam 3
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Terms in this set (46)
Four methods used to evaluate capital budgeting
1) Payback Period
2) NPV (Net Present Value)
3) IRR (Internal Rate of Return)
4) PI (Profitability Index)
Decision rule for payback period
Accept if the payback period is less than
some preset (arbitrary!!) limit
3 advantages and 4 disadvantages of payback period
Advantages
1) Easy to understand
2) Adjusts for
uncertainty of later
cash flows
3) Biased towards
liquidity
Disadvantages
1) Ignores the time value
of money
2) Requires an arbitrary
cutoff point
3) Ignores cash flows
beyond the cutoff date
4) Biased against longterm
projects, such as
research and
development, and new
projects
Decision rule for NPV
If NPV is positive, accept the project
Advantages of using the NPV method
1) Meets all desirable criteria
a) Considers all CFs
b) Considers TVM
c) Adjusts for risk
d) Can rank mutually exclusive projects
2) Directly related to increase in VF
3) Dominant method; always prevails
What does it mean if NPV=0
IRR is the discount rate
Decision rule for IRR
Accept the project if the IRR is greater than the required return
Advantages of using IRR method
1) Preferred by some practitioners who prefer interest rates
2) If the IRR is high enough, you may not need to estimate a
required return
3) Considers all cash flows
4) Considers time value of money
5) Provides an indication of risk
Disadvantages of using IRR method
1) Can produce multiple answers
2) Cannot rank mutually exclusive projects
3) Reinvestment assumption flawed
non-conventional cash flow
Cash flow sign changes more than once
Independent vs. mutually exclusive project definitions
Independent - the CFs of one are unaffected by the acceptance of the
other
Mutually exclusive - the cash flows of one CAN be adversely impacted by
the acceptance of the other
Two reasons NPV profiles cross
1) Size (scale) differences
- high discount rate favors small
projects
2) Timing differences
-high discount rate favors early CFs
Decision rule for PI
If PI > 1.0 Accept
Advantages and disadvantages of PI
Advantages
1) Closely related to
NPV, generally
leading to identical
decisions
• Considers all CFs
• Considers TVM
2) Easy to understand
and communicate
3) Useful in capital
rationing
Disadvantages
1) May lead to incorrect
decisions in
comparisons of
mutually exclusive
investments (can
conflict with NPV)
the "stand-alone principle"
allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
Definition and use of incremental cash flow
the additional cash flow
that a firm receives from taking on a new project
Relevance of 6 cash flows
1) "Sunk" Costs ...............N
2) Opportunity Costs .......Y
3) Side Effects/Erosion......Y
4) Net Working Capital......Y
5) Financing Costs............N
6) Tax Effects ..................Y
sunk costs
Any cost that has already been paid (or that you are
obligated to pay) that won't change based on
accepting/rejecting a project should be EXCLUDED from the
project analysis
opportunity costs
The next-best thing that you could do if you chose not to do a
project should be included as a cost of the project
side effects/erosion and the difference between them
If the sales from a new project will either increase or decrease
sales/costs in one of your existing product lines, these
costs/benefits must be included as a cash flow in the new
project analysis.
Meaning and recovery of net working capital in a project
Sometimes new projects require an investment (cash
outflow) in new working capital (current assets - current
liabilities)
financing costs
Any costs associated with financing (dividends paid, interest
paid, new debt issued/repaid, new stock issued/repurchased)
are EXCLUDED from the project analysis
tax effects, and how a tax shield is created
Depreciation is not a cash flow itself, but it impacts taxes
paid. Therefore we must include the tax shield of
depreciation as a cash flow, but NOT depreciation itself
Definition of Pro Forma, and Pro Forma statements
Pro Forma means "projected".
These statements represent the future cash flows we expect
from the new project
Know the two types of depreciation, the definition of straight-line depreciation, and why MACRS depreciation gives a higher NPV
Straight-line depreciation
D = (Initial cost - salvage) / number of years
Using MACRS depreciation rates gives a higher NPV. Why?
1. More depreciation (early years) = higher tax break (early
years) = higher CFs (early years).
2. Since there are higher CFs early (get discounted less when
discounting back to the present), the resulting NPV is higher.
Know the difference between tax effects on salvage value when selling above and below book value
If you sell an asset above its book value, you must pay taxes
on the gain.
If you sell an asset below its book value, you can deduct the
loss from taxable income.
Forecasting risk
The amount of forecasting risk depends on how sensitive
NPV is to changes in cash flow estimates
• The more the sensitivity, the greater the forecasting
risk
Meaning of scenario analysis
Examines several possible situations. Often 3
situations are considered:
1) Worst case
2) Base case (most likely case)
3) Best case
Three problems with scenario analysis
1) Considers only a few possible outcomes (often only 3
outcomes).
2) Assumes perfectly correlated inputs
- All "bad" values occur together and all "good" values
occur together
3) Have to estimate the range of input values that you think is
reasonable, but it is hard to know exactly what it
reasonable.
Meaning of sensitivity analysis
Shows how changes in one input variable affect NPV or
IRR
Three strengths and three weaknesses of sensitivity analysis
Strengths
1) Provides indications of stand-alone risk.
2) Identifies dangerous variables.
3) Gives some breakeven information.
Weaknesses
1) Does not reflect diversification.
2) Says nothing about the likelihood of change in a
variable
3) Ignores relationships among variables.
Two disadvantages of sensitivity and scenario analysis
Neither provides a decision rule.
- No indication whether a project's expected return is
Both ignore diversification.
- Measures only stand-alone risk, which may not be the
most relevant risk in capital budgeting.
Know total dollar return vs total percent
Total dollar return = the return on an investment measured
in dollars
Total percent return = the return on an investment
measured as a percentage of the original investment
Difference between dividend yield and capital gains
D1/P1 = Dividend yield
(D1+P1-Po)/Po = Capital Gains Yield
Of the five classes of stocks, bonds, and bills, these five groups and the order in which they have returns
Large Stocks 11.8%
Small Stocks 16.5%
Long-term Corporate Bonds 6.4%
Long-term Government Bonds 6.1%
U.S. Treasury Bills 3.6%
Inflation 3.1%
Be able to explain the risk-return tradeoff
1) There is a reward for bearing risk
2) The greater the potential reward, the greater the risk
Definition of risk-free rate
Rate of return on a riskless investment
risk premium
Excess return on a risky asset over the risk-free rate
How risk is measured
Risk is measured by the dispersion, spread, or volatility of returns
Difference between variance and standard deviation
Variance = VAR(R) or σ
2
• Common measure of return dispersion
• Also call variability
Standard deviation = SD(R) or σ
• Square root of the variance
• Sometimes called volatility
• Same "units" as the average
Definition of a normal distribution, and whether it describes asset returns
A symmetric frequency distribution
-yes, large common stocks
Definition of arithmetic and geometric returns, and how they differ
Arithmetic average:
• Return earned in an average period, adding multiple
periods and dividing by total periods
-Arithmetic returns will always be the same or higher than
geometric returns
Geometric average:
• Average compound return over multiple periods
-Geometric average < arithmetic average unless all the
returns are equal
Explain efficient capital markets and the efficient market hypothesis
Stock prices are in equilibrium
- does not mean that
you can't make money
Understand "strong form efficiency"
Information in stocks = Public and private
Understand "semistrong form efficiency"
Information in stocks = only publicly available info
Understand "weak form efficiency"
Information in stocks = only past price and volume data
;