Capital Budgeting I

Question 1

what is payback period

Answer 1

the number of years required to recover a project’s cost ie how long it takes the business to get the money back

Question 2

is it better to have a shorter or longer payback period

Answer 2

shorter

Question 3

strengths of payback period

Answer 3

tells us how liquid project is

easy to calculate and understand

Question 4

weaknesses of payback period

Answer 4

ignores time value of money

ignores cash flows after end of payback period

payback period is arbitrary date

Question 5

generally is it better to get payments upfront or a stream of payments in the future

Answer 5

now

so you can invest them at the current interest rate

Question 6

present value formula for cash flow C for a period of n

Answer 6

C / (1+r)^n

Question 7

what is discounted payback

Answer 7

payback with presesnt values

Question 8

what is NPV

Answer 8

net present cash flow

sum of PV of all future cashflows - initial cost

Question 9

accept when NPV

Answer 9

> 0

Question 10

reject when NPV

Answer 10

< 0

Question 11

is a higher or lower NPV better

Answer 11

higher

Question 12

what is a NPV profile

Answer 12

shows NPV at different interest rates on a graph

x axis = rate
y axis = NPV

Question 13

what is the IRR

Answer 13

internal rate of return

rate when NPV = 0

ie the present value of the future cash flows are equal to the initial cost

Question 14

how is irr calculated

Answer 14

trial and error

spreadsheet

Question 15

should you accept if IRR is greater than cost of capital

Answer 15

yes

some return will be left over, ie making more than initial investment

Question 16

what is the crossover rate

Answer 16

the cost of capital at which the NPV of two projects are equal

Question 17

why is crossover rate useful in capital budgeting

Answer 17

informs the investing company about a scenario when a currently feasible project will no longer be feasible

Question 18

how to find the crossover rate

Answer 18

• find cashflow difference between two projects
• treat this as new project
• if it does not go from negative to positive, one project is always better than the other
• otherwise proj x is better before rate and proj y is better after rate

Question 19

reasons NPV profiles cross

Answer 19

• cashflow size and timing differences (early cashflow better with high cost of capital)

Question 20

what is a normal cash flow

Answer 20

initial negative cost

followed by a series of positive cash inflows

one change in sign

Question 21

what is a non normal cash flow

Answer 21

two or more changes in sign

Question 22

example of when there would be a non normal cash flow

Answer 22

when there is a cost to close a project

Question 23

what is a weakness of irr

Answer 23

cannot deal with non normal cash flows

can result in multiple irrs

Question 24

how to overcome problem of multiple irrs

Answer 24

modified irr

Question 25

how does modified irr work

Answer 25

group cash flows bringing all costs to the start and pushing all cash flows to the end (at discount rate)

FV(inflows) = PV(costs)(1+MIRR)^n

solves for MIRR

Question 26

what is the profitability index

Answer 26

PV of future cash flows / initial cost

Question 27

what are some other aspects to take into account when capital budgeting

Answer 27

inflation
tax
working cpital

Question 28

what is the money/nominal rate of return

Answer 28

real return + inflation

Question 29

what is the real return

Answer 29

return investor would want if there was no inflation

Question 30

real and nominal and inflation rates equation

Answer 30

(1+i) = (1+r)(1+h)

i = money discount rate
r = real rate
h = inflation rate

Question 31

what are nominal cash flows

Answer 31

increased to take inflation into account

Question 32

`what are the two methods for calculating NPV with inflation

Answer 32

real method = do not inflate cash flows and discount at real rate

nominal method = inflate cash flows and discount at money rate

two give the same NPV

Question 33

how to calc NPv with specific inflation rates

Answer 33

inflate cash flows at specific rates

discount using money rate