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BU 393 > Chp 9: Capital Budgeting Intro & Techniques > Flashcards

Chp 9: Capital Budgeting Intro & Techniques Flashcards

1
Q

what decision has the greatest impact on a business’s future than any other decision it makes?

A

investment decisions

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2
Q

what does capital refer to

A

long term securities and investments

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3
Q

define capital budgeting - 2 points

A

1) method for evaluating long term investment opportunities in which all cash flows are discounted to the present
2) process of deciding which long term investments or projects a firm will acquire

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4
Q

goal of financial manager and what do they need to do

A

increase shareholder wealth so they need to invest funds in projects that increase shareholder wealth

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5
Q

explain NPV analysis

A

continuous process when applied to big projects where sunk costs have to be ignored and the focus moves to completing the project

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6
Q

steps in capital budgeting process

A

1) identification of opportunities
2) evaluation of opportunities
3) selection
4) implementation
5) post audit

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7
Q

explain step 1 in capital budgeting process: identification of opportunities - 2 points

A

1) Firm’s need some method of identifying opportunities to the attention of managers
2) Employees on front lines must have both incentives and means to communicate ideas to those who implement them

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8
Q

explain step 2 in capital budgeting process: evaluation of opportunities

A

All costs and benefits need to be identified and analyzed

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9
Q

explain step 3 in capital budgeting process: selection

A

Projects must be ranked and selection because of limited funds or because of human/physical constraints the firm faces - they can’t accept everything

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10
Q

explain step 4 in capital budgeting process: implementation

A

Costs must be monitored and project risk must be evaluated

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11
Q

explain step 5 in capital budgeting process: post audit - 2 points

A

1) Once the project is completed, compare costs and revenues with original projections.
2) Employees must be responsible for errors in projections to give them an incentive to do be more accurate next time

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12
Q 
Which of the following is NOT necessarily a step in the capital budgeting​ process?
A.Post audit.
B.Project rejection.
C.Evaluation of opportunities.
D.Identification of opportunities.
A

project rejection

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13
Q 
The steps of capital budgeting include all of the following​ except:
A.Pre Audit.
B.Post Audit.
C.Selection.
D.Evaluation of Opportunities.
A

pre audit

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14
Q

An investment may change the whole face of a firm. True or false?

A

true

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15
Q

5 things a good capital budgeting decision tool should do

A

1) Use all the cash flow
2) Account for time value of money
3) Account for risk
4) Able to rank mutually exclusive projects
5) Have a link to increased firm value

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16
Q

5 capital budgeting decision tools

A

1) payback period (PB)
2) NPV
3) profitability index (PI)
4) IRR
5) modified IRR

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17
Q

3 points to payback period

A

1) Number of years required to recapture initial investment
2) = initial investment / annual cash flow
3) No decision criteria

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18
Q

3 points to NPV

A

1) The present value of all cash flows
2) = PV(cash inflows) - PV(cash outflows)
3) Accept if greater than or equal to 0

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19
Q

3 points to profitability index

A

1) Ratio of the PV of cash inflows to outflows
2) = PV (inflows) / PV (outflows)
3) Accept if greater than or equal to 1

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20
Q

2 points to IRR

A

1) Interest rate that sets the PV of cash inflows equal to PV of outflows
2) Accept if greater than or equal to cost of capital

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21
Q

2 points to modified IRR

A

1) Interest rate that sets PV of outflows equal to FV of inflows, computed at firm’s cost of capital
2) Accept if greater than or equal to cost of capital

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22
Q

True or​ False? Based on the Explain​ it! video and on the​ table, the decision criteria is used to evaluate the results of a capital budgeting analytic method so as to make the​ accept/reject decision.

A

true

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23
Q

single sentence good and bad thing for payback period

A

The easiest to compute but theoretically the worst evaluation method

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24
Q

payback period - what to do with unequal cash flow

A

make table to cash inflow and balance and when balance is last negative do balance/next cash inflow to get number of months in between. Multiply fraction by 12 to get months and round up. Note: balance for that year should be subtracted by cash inflow in that year.

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25
Q

2 advantages of payback period

A

1) Simple

2) Provides liquidity info (shorter the payback period, the greater the project’s liquidity)

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26
Q

4 disadvantages of payback period

A

1) No clearly defined accept/reject criteria
2) No risk adjustment (risky CF treated same as low risk CF)
3) Ignores cash flows beyond payback period
4) Ignores time value of money (large and early CF are valued as much as small, early CF)

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27
Q

when is payback period often used?

A

when some projects are too small to justify complexity of other methods

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28
Q

define discounted payback method

A

amount of time it takes for a project to recoup the investment and cost of capital

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29
Q

what does discounted payback method take into account?

A

This method takes into account time value of money, but not the other problems

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30
Q

All of the following are weaknesses of the payback period technique​ except:
A.Ignores time value of money.
B.Difficulty of calculation.
C.No clearly defined​ accept/reject criteria.
D.Ignores cash flows beyond payback period.

A

B.Difficulty of calculation.

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31
Q

Of the different techniques available for evaluating cash​ flows, which is technically the​ worst?
A.The internal rate of return​ (IRR)
B.The net present value​ (NPV)
C.The modified internal rate of return​ (MIRR)
D.The payback period
E.The profitability index​ (PI)

A

payback period

32
Q

why is NPV widely used?

A

Most popular and theoretically sound evaluation tool

33
Q

what does positive NPV mean

A

Positive NPV means current value of income exceeds current value of expense for project

34
Q

what does negative NPV mean

A

Negative NPV means project costs more than it will bring in

35
Q

what time does annuity find PV?

A

an annuity finds PV to period before first cash flow

36
Q

3 advantages of NPV

A

1) Uses time value of money
2) Clear decision criteria
3) Discount rate adjusts for risk

37
Q

2 disadvantages of NPV

A

1) Can be difficult for people without background in financial theory
2) Of little help when company must select among group of positive NPV projects

38
Q

NPV relationship to firm value

A

NPV has a 1:1 relationship when increased firm value. If NPV of a project is $10, this means the value of the firm will increase by $10 by accepting the project.

39
Q

what discount rate is used to evaluate capital budgeting projects and what it reflects

A

firm’s cost of capital. It reflects the risk of the firm and the firm’s average required return on its investments.

40
Q

in excel what do you have to do for NPV?

A

manually subtract out the beginning cash outflow

41
Q

define NPV profile

A

graphs NPV at various discount rates (as discount rate rises, NPV decreases to account for risk)

42
Q

what does NPV profile show

A

Shows sensitivity of the project to the firm’s cost of capital

43
Q

x and y axis for NPV profile

A

Various discount rates are on the x axis and NPV is on the y axis

44
Q

NPV profile: graphing 2 projects at certain discount rate

A

At a certain discount rate, if we graph 2 projects, the one that is higher is the one to choose

45
Q

why do we do a sensitivity analysis?

A

cost of capital is hard to estimate

46
Q

how do we find NPV when discount rate is 0?

A

summing the cash flows

47
Q

define profitability index

A

Provides a measure of the bang for the buck provided by investing in the project

48
Q

what does profitability index tell you

A

Tells you how many dollars in PV terms you receive per dollar of investment

49
Q

2 formulas for profitability index

A

1 + NPV/PV(cash outflow) or = PV(inflow)/PV(outflow)

50
Q

PI when NPV =0

A

1

51
Q

PI when NPV > 0

A

> 1

52
Q

what 3 methods give same accept/reject decision and why?

A

NPV, IRR, PI

53
Q

why must firm participate in capital rationing

A

Firm’s must limit its capital budget (ration its capital) due to real world constraints so firm’s need to rank projects

54
Q

what does ranking projects by PI tell the firm?

A

Ranking project by PI lets the firm know which projects generate the highest return per dollar invested

55
Q

when does ranking PI only work?

A

Ranking by PI works only if projects use all of the budgeted capital. The goal is to choose projects that combine to the highest NPV and sometimes the top ranked PI projects don’t do that

56
Q

PI advantage

A

useful as aid in ranking

57
Q

PI disadvantage

A

should not replace NPV as it can rank projects incorrectly when capital is rationed and does not provide measure of increase in firm value like NPV

58
Q 
Question: Which capital budgeting technique is most useful for ranking projects when faced with capital​ rationing?
A.IRR.
B.Payback period.
C.NPV.
D.PI.
A

PI

59
Q

True or​ False? Using the PI to rank projects will always result in maximizing NPV.

A

false

60
Q

Which of the following is an advantage of the net present value​ (NPV) technique for evaluating cash​ flows?
A.Easy comparison of separate NPV projects.
B.Ease of understanding.
C.Discount rate adjusts for risk.
D.100% accurate.

A

discount rate adjusts for risk

61
Q

All of the following are true about profitability index​ (PI) except:
A.Calculated by dividing the present value of inflow by the present value of the outflows.
B.Will always give the same​ accept/reject decision as NPV.
C.Works well as a supplement for the NPV method.
D.Is best used by itself.

A

is best used by itself

62
Q

define IRR

A

Discount rate that sets PV of cash inflows equal to present value of cash outflows (sets NPV = 0)

63
Q

what is the hurdle rate?

A

cost of capital

64
Q

2 advantages of IRR

A

1) Easy to interpret and explain

2) Investors like to speak in terms of annual percentage returns when evaluating investment options

65
Q

5 disadvantages of IRR

A

1) Assumes cash flows are reinvested at IRR when they are received
2) Cannot be used to rank mutually exclusive projects because it does not evaluate projects at particular discount rates
3) Ignores differences in scale since cash flows are converted to percentages
4) Will generate multiple IRRs(or no IRR solution) if cash flows change direction.

66
Q

on NPV profile, where can we find IRR?

A

On an NPV profile, the IRR (or multiple) are where the graph crosses the x axis

67
Q

what happens if there are multiple IRRs

A

we cannot use IRR, it is invalid

68
Q

Question: Which of the following is NOT a disadvantage of the IRR method for capital​ budgeting?
A.The reinvestment assumption may lead to wrong ranking decisions.
B.Results are hard to interpret.
C.May not be a single solution.
D.IRR does not provide information for project scale.

A

B.Results are hard to interpret.

69
Q

Question: The problem with the reinvestment rate assumption​ is:
A.IRR assumes all cash flows are not reinvested.
B.IRR assumes all cash flows are reinvested at the IRR.
C.IRR assumes all cash flows are reinvested at the highest return available.
D.IRR assumes all cash flows are reinvested at the cost of capital.

A

B.IRR assumes all cash flows are reinvested at the IRR.

70
Q

what are future value of cash flows called?

A

terminal value

71
Q

what does modified IRR solve?

A

Solves the IRR problem of reinvestment rate because cash flows are compounded at cost of capital. Also solves problem of changing CF signs resulting in multiple IRR’s

72
Q

explain MIRR in terms of interest rate

A

Is the interest rate that grows the present value to equal the future value

73
Q

MIRR: where are cash inflows compounded to?

A

Cash inflows are compounded to the point at which the last cash inflow is received

74
Q

The internal rate of return​ (IRR) can be defined​ as:
A.The results of the NPV converted to a ratio.
B. The discount rate that sets NPV to 0.
C.The number of years required to recover the initial investment.
D.The sum of the future cash flows discounted back to the current period.

A

B.The discount rate that sets NPV to 0.

75
Q

The difference between the internal rate of return​ (IRR) and the modified internal rate of return​ (MIRR) is:
A.MIRR is a simpler version of IRR that does not require a calculator to solve.
B.IRR is more accurate.
C.MIRR solves the reinvestment rate assumption problem.
D.IRR deals with outflows where the MIRR deals with inflows.

A

C.MIRR solves the reinvestment rate assumption problem.

76
Q

What major problem with IRR does the MIRR​ solve?
A.The ranking problem.
B.Evaluation of the timing of the cash flows.
C.The scaling issue.
D.The reinvestment rate assumption issue.

A

D.The reinvestment rate assumption issue.

77
Q

what do we need to pay attention to payback period?

A

if payback period exceeds years of revenue, there is no payback (if PV cost exceeds PV revenues)

BU 393 (3 decks)

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