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Flashcards in Chapter 10 Deck (30):
1

capital

long term assets used in production

2

budget

a plan that outlines projected expenditures during a future period

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capital budgeting

the whole process of analyzing projects and deciding which ones to accept and thus include in the capital budget

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differences in security valuation and capital budgeting

stocks and bonds exist in the secuurities markets and investors chose from available set, most investors have no influence over the cash flows produced by their investments

5

Net Present Value

the present value of a projects cash inflows minus the present value of its costs, tells us how much the project contributes to shareholder wealth.

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Larger NPV means

the more value the project adds and the higher the stock price

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independent projects

those whose cash flows are not affected by other projects

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mutually exclusive projects

two different ways of accomplishing the same result, so if one is accepted the other must be rejected

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Internal Rate of Return

the discount rate that forces the PV of the inflows to equal the initial cost. the is equivalent to forcing NPV to zero. an estimate of the project's rate of return, similar to ytm on a bond

10

Multiple Internal Rates of Return

if a project has nonnormal cash flwos (more than one sign change) then it has multiple IRRs.

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Assumption of the NPV calculation

cash inflows can be reinvested at the projects WACC

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IRR assumption

cash flows can be reinvested at the IRR

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Why is assuming reinvestment at the WACC better

firms with good investments usually have access to debt and equity markets and can raise all of the capital it needs at the going rate, the WACC

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problem with the IRR

overstates the expected return for accepted projects because cash flows cannot generally be reinvested at the IRR itself

15

Modified IRR (MIRR)

similar to the IRR but assumes that cash flows are reinvested at the WACC

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advantages of MIRR over IRR

IRR assumes cash flows are reinvested at IRR, MIRR assumes reinvestment at COC, so MIRR is a better gauge of profitability. MIRR eliminates Multiple IRR problem

17

Is MIRR as good as NPV?

for indpendent projects NPV, IRR, MIRR will reach same coclusion. for mutually exclusive, NPV is best

18

Net Present Value Profile

find the project's NPV at a number of different discount rates and then plan those values to create a graph

19

crossover rate

where to npv profile lines cross, conflict if WACC is to the left, no conflict if to the right

20

What happens to NPV when COC increases

if cash flows happen in later years, sharp decline in npv. earlier cash flows not severely effected

21

Profitability Index

shows the relative profitability of any project, or the present value per dollar of initial cost

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payback period

the number of years required to recover the funds invested in a project from its operating cash flows

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three flaws with regular payback

1. dollars received in different years all given the same weight, no time value considered 2. cash flows beyond payback year given no consideration 3. unlike npv and irr, there is no link back to investor welath gaines from the project

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discounted payback

cash flows are discounted at the WACC and then used to find the payback

25

When should we worry about analysis of unequal lives

when looking at mutually exclusive projects with unequal lives

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economic life

the life that maximizes npv and thus shareholder wealth

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physical or engineering life

number of years of project

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optimal capital budget

the set of projects that maximizes the value of the firn

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complications of optimal capital budget

1. coc might increase as size of budget increase making it hard to know proper discount rate to use 2. firms may set an upper limit to size of capital budgets

30

capital rationing

reluctance to issue new stock, constraints on nonmonetary resources-may not have resources to accept all projects that look good. controlling estimation bias-make management use unralistically high coc in estimations to limit bias