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MGT8803 > Finance > Flashcards

Finance Flashcards

1
Q

What is Capital Budgeting?

A

The process of determining exactly which assets to invest in and how much to invest.

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2
Q

What are the 4 steps of Capital Budgeting?

A

Identification
Evaluation
Selection
Implementation

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3
Q

What types of investment are part of the Identification phase of Capital Budgeting?

A
  • Required Investment
  • Replacement Investment
  • Expansion Investment
  • Diversification Investment
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4
Q

What types of investment are part of the Evaluation phase of Capital Budgeting?

A
  • Expected Cash Flow Stream
  • Discount Rate
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5
Q

What types of tools are used in the Selection phase of Capital Budgeting?

A
  • Net present value
  • Profitability index
  • Internal rate of return
  • Payback Period
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6
Q

What is the formula for calculating Future Value?

A

FV_t = PV*(1+r)^t

in Excel: FV(rate, time, ,-PV)

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7
Q

What is the Present Value method?

A

The present value is the amount of money you need to invest today in order to duplicate some future dollar amount.

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8
Q

What is the formula for calculating Present Valeu?

A

PV = FV_t / (1+r)^t

in Excel: PV(rate, time, ,-FV)

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9
Q

What is the formula for determining an unknown rate of return?

A

in Excel: RATE(FV,,t, -PV)

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10
Q

What formula should you use in Excel to determine an unknown number of periods?

A

Excel = NPER(rate, , PV, -FV)

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11
Q

What is the excel formula for calculating the present value of an annuity?

A

PMT()

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12
Q

When would you accept a project based on Net Present Value?

A

If NPV > 0 you accept the project

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13
Q

For large projects, are early cash flows generally positive or negative?

A

Negative

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14
Q

Describe Independent vs Mutually Exclusive project types.

A

Independent projects do not depend on the acceptance or rejection of other projects.

If two projects are Mutually Exclusive, you can only choose one of them.

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15
Q

What is the Payback Period?

A

A project’s payback period is the number of periods (typically years) required for the sum of the project’s expected cash flows to equal its initial cash outlay.

The time it takes for a firm to recover its initial investment.

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16
Q

What is the Internal Rate of Return?

A

It’s the discount rate that makes the net present value of the project = 0.

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17
Q

What is the acceptance criteria when using the internal rate of return?

A

Accept the project if the IRR is greater than the cost of capital.

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18
Q

What is the Profitability Index?

A

Aka the benefit/cost ratio

PV of an investment’s future cash flows / initial cost

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19
Q

What are 3 problems with IRR?

A
  1. Multiple IRRs can exist
  2. The Scale Problem
  3. The Timing Problem
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20
Q

When would there be multiple IRRs?

A

When the cashflows become positive, then negative.

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21
Q

What is the Scale Problem?

A

Eg. making 100% return on $1 vs 50% return on $1,000

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22
Q

What is the timing problem?

A
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23
Q

When would NPV and IRR decision results be different?

A
  1. When there are non-conventional cash flows (the signs change more than once [think of the mining example])
  2. When there are mutually exclusive projects with substantially different initial investments and timings of cash flows.
24
Q

If you want to determine the amount of capital expenditures a company made during the previous year, what financial document and under what heading should it be found?

A

Cash Flow statement under Cash Flow Investments

25
Q

If project A has an estimated IRR of 18% and project B has an IRR of 22% and the projects are independent, what is the estimated IRR if we decide to do both projects?

A

Between 18% and 22%

26
Q

What is the method of identifying projects that focuses on the creating the most economic value?

A

Net Present Value (the professor’s favorite)

27
Q

If capital projects with conventional cash flows are _____ the NPV and the IRR methods should result in consistent “accept” or ‘reject” decisions.

A

Independent

28
Q

What excel function should be used to find the rate of return required to get a future value after N periods of time?

A

RATE(periods,BLANK,current value, -Future Value)

29
Q

How are sunk costs treated in decision making?

A

They are not relevant for present decision

30
Q

How are test marketing costs treated in decision making

A

They are expenses that get expensed.

31
Q

How are erosion costs treated in decision making?

A

Cash flows transferred to a new project from sales and customers of other products of the firm

32
Q

How are opportunity costs treated in decision making?

A

Lost revenues from alternative uses of the asset.

33
Q

What is the after tax cash flow (ATCF) equation?

A

ATCF = (Revenue - Costs - Depreciation)(1-Tax) + Depreciation

34
Q

What are the Firm Valuation methods discussed in class?

A

Discounted Cash Flows (DCF) and Comparables

35
Q

How do you calculate the combined IRR of a multiple independent projects?

A

Sum up the cashflows for each year and do IRR on that

36
Q

What’s the formula for Weighted Average Cost of Capital?

A

WACC=Cost of Debt(1-Tax Rate)(Debt/(Debt+Equity))+Cost of Equity*(Equity/(Debt+Equity))

37
Q

How do you calculate Market Value Add (MVA)

A
38
Q

What are examples of Firm Specific Risk?

A
  • A firm’s CEO suddenly gets killed
  • A company loses a major lawsuit
  • A wildcat strike in one of the firm’s plants
  • an unexpected entry of a competitor
39
Q

What are examples of Market Risk?

A
  • An unexpected increase in long-term interest rates
  • Changes in monetary or fiscal policy
  • U.S. Congress votes on major tax cut
  • An unexpected decline in the value of the USD
40
Q

What is the relationship between Beta and the Cost of Equity?

A

Cost of Equity = Treasury Rate + (market risk premium * Beta)

41
Q

What are 2 methods for determining a company’s valuation?

A

Discounted Cash Flow
Comparables

42
Q

What is the formula for getting the Free Cash Flow of a firm?

A

CF_t = EBIT_t*(1-T) + Depr_t - Capex_t - Change in NWC_t

43
Q

How do you calculate the Terminal Value?

A

TV_5 = CF_5*g/(r-g)
then you need to discount it for time 5

44
Q

What are some weakness of using Discounted Cash Flow?

A

-Point Estimate
- Beta Estimation from Comparables
-Terminal Values play crucial role
-Changing Capital Structure of Effective Tax Rates
- Assumes WACC is constant and included in discount

45
Q

What are some of the Characteristics we would look for in a Comparable for Market evaluation?

A
  • Risk
  • Growth Rate
    -Capital Structure
    -Size and Timing of Cash Flows
46
Q

What are some Weaknesses of using Comparables for firm Valuation?

A

It’s not great for valuation of Private Firms
Financial Info in not often available
Valuations of what you’re comparing many be misguided.

47
Q

What are strengths of using Comparables of r firm valuation?

A

-Quick to use
-Simple to Understand
-Commonly used
-Marked Based

48
Q

What are some strengths of using Discounted Cash Flow for firm Valuation?

A

Theoretically sound

49
Q

What’s the difference between Accounting Profits and Economic Profits?

A

Accounting Profits = Total Capital * Return on Total Capital

Economic Profits = Accounting Profits - (Opportunity CC * Total Capital) [or Capital Charge]

50
Q

What are some measures of financial performance?

A

-Return on Sales = NOPAT(net operating profit after tax)/Sales
-Capital Turnover = sales / total capital
-Return on Total Capital = NOPAT/TC

51
Q

How do you calculate economic profit?

A

Economic profit = Accounting Profit - Capital Charge
= NOPAT - (r x TC)
=(r-r)TC

52
Q

What’s the relationship between NPV and EVA?

A

NPV = discounted EVA

53
Q

What is Market Value Add?

A

MVA = Market Value of Equity - Book Value of Equity
=(stock price/share - book value/share) * shares outstanding

54
Q

What are 3 ways a company can create economic value?

A
  1. Manage: Increase operating efficiency to improve spread between r* and r
  2. Built: Invest in businesses/projects with positive spreads between r* and r
  3. Harvest: Withdraw capital from operations where r* < r
55
Q

What’s the formula to calculate a firms CC

A

WACC = Cost of Debt(1-T)[Debt/(Debt+Equity)] + Cost of Equtiy*Equity/(Debt + Equity)

MGT8803 (4 decks)

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