Topic 1 - basic concepts about capital budgeting

Question 1

Three questions that Corporate Finance addresses

Answer 1

1. What long-term investments should the firm choose
2. How should the firm raise funds for the selected investments
3. How should short-term assets be managed and financed

Question 2

What’s the capital budgeting decision?

Answer 2

What long-term investments should the firm choose?

Question 3

What’s the capital structure decision?

Answer 3

How should the firm raise funds for the selected investments?

Question 4

The Financial Manager’s primary goal is to increase the value of the firm by

Answer 4

1. selecting value creating projects
2. making smart financing decisions

Question 5

What is the agency problem

Answer 5

Agency relationship:
* principal hires an agent to represent his/her interest
* stockholders hire managers to run the company

Agency problem:
* conflict of interest between principal and agent

Question 6

When should an investment be purchased?

Answer 6

When the present value of the cash inflow is greater than the cost. In other words, when the Net Present Value (NPV) is positive, the investment should be purchased

Question 7

What is a perpetuity

& formula

Answer 7

A constant stream of cash flows that lasts forever

Question 8

What is a growing perpetuity

& formula

Answer 8

A stream of cash flows that grows at a constant rate forever

Question 9

What is an annuity

& formula

Answer 9

A stream of constant cash flows that lasts for a fixed number of periods

Question 10

What is a growing annuity

Answer 10

A stream of cash flows that grows at a constant rate for a fixed number of periods

Question 11

Mutually exclusive projects VS Independent projects

Answer 11

• Mutually exclusive projects: only ONE out of several potential projects can be chosen
• Independent projects: accepting or rejecting one project does not affect the decision of other projects

Question 12

Why use NPV?

Answer 12

Accepting positive NPV projects benefits shareholders:
* NPV uses cash flows
* NPV uses all the cash flows of the project
* NPV discounts the cash flows properly

Reinvestment assumption: the NPV rule assumes all cash flows are reinvested at the discount rate

Question 13

What is the payback period?

Answer 13

The number of years it takes to recover initial costs

Question 14

The payback period method

Advantages and disadvantages

Answer 14

Disadvantages:
* ignores the time value of money
* ignores cash flows after payback period
* biased against long-term projects
* required an arbitrary acceptance criteria
* a project accepted based on the payback criteria may not have a positive NPV

Advantages:
* easy to understand
* biased toward liquidity

Question 15

what is the decision rule?

Answer 15

accept the project if it pays back on a discounted basis within the specified time

Question 16

On the IRR

Answer 16

• IRR: the discount rate that sets NPV to zero
• Minimum acceptance criteria: accept if the IRR exceeds the required return
• Ranking criteria: select alternative with the highest IRR
• Reinvestment assumption: all future cash flows assumed reinvested at the IRR

Question 17

Advantages & disadvantages of IRR

Answer 17

Disadvantages:
* does not distinguish between investing and borrowing
* IRR may not exist, or there may be multiple IRRs
* problems with mutually exclusive investments

Advantages:
* easy to understand and communicate

Question 18

Limitation to the average maturity period (calculating IRR manually)

Answer 18

it only worksif there are no negative cash flows, except the initial investment; or all values are negative, except the initial one

Question 19

NPV vs IRR

Answer 19

• NPV & IRR will generally give the same decision about the feasibility of the project
• exceptions:
• non-conventional cash flows: cash flow signs change more than once (possible IRR inconsistency)
• mutually exclusive projects: initial investments are substantially different or timing of cash flows is substantially different

Question 20

Net present value

Answer 20

• Difference between market value and cost
• Accept the project if the NPV is positive
• Preferred decision criterion

Question 21

Internal rate of return

Answer 21

• Discount rate that makes NPV = 0
• Take the project if the IRR is greater than the required return
• Same decision as NPV with conventional cash flows
• IRR is unreliable with non-conventional cash flows or mutually exclusive projects

Question 22

Payback period

Answer 22

• Length of time until initial investment is recovered
• Take the project if it pays back in some specified period
• Does not account for time value of money, and there is an arbitrary cutoff period

Question 23

Discounted payback period

Answer 23

• Length of time until initial investment is recovered on a discounted basis
• Take the project if it pays back in some specified period
• There is an arbitrary cutoff period