Reading...
Play button
Play button
Use LEFT and RIGHT arrow keys to navigate between flashcards;
Use UP and DOWN arrow keys to flip the card;
H to show hint;
A reads text to speech;
23 Cards in this Set
- Front
- Back
|
How to solve payback period?
|
Net Initial Investment
/ Average expected cash flow (or net cash savings) Average exp. CF = CF savings (net of tax) + Tax Depreciation shield = Net cash savings |
|
|
Advantages and Disadvantages of Payback Period Method
|
+ Easy to Understand
+ Emphasis on Liquidity: how long it will take to pay back - TVM is ignored - Reinvestment cash flows are not considered - Project profitability is neglected - After initial investment is recovered, cash flows after are ignored. |
|
|
Advantages and Disadvantages of DCF
|
+ Best for long - run decisions
+ Includes TVM - Single interest rate, doesn't adjust w/ time |
|
|
Objective of Payback Period:
Objective of Discounted Payback Period: |
- After tax cash inflow to recover the initial investment.
- Evaluate how quickly new ideas are converted into profitable ideas. **Often used in companies that experience rapid tech. changes. |
|
|
Advantages and Disadvantages of Discounted Payback:
|
Same as payback period method:
**EXCEPT** it includes TVM |
|
|
Objective of Net Present Value Method:
|
It focuses an investment that will yield returns in an amount in excess of a management designated hurdle rate.
If NPV is positive = accept |
|
|
What does NPV ignore?
|
Depreciation (unless it is a tax shield)
And Method of Funding |
|
|
Which is better NPV or IRR?
|
NPV is considered better b/c it is flexible enough to consistently handle uneven cash flows or inconsistent rates of return for each year.
|
|
|
Advantages and Disadvantages of NPV:
|
+ Very flexible and can be used when there is no constatnt rate of return required for each year of the project
+ Best SINGLE technique for cap. budgeting. - Does not provide true rate of return on investment, it uses the management hurdle rate. |
|
|
How to solve NPV?
|
1) Calculate Tax Depreciation shield (net of tax)
2) Calculate Annual Cash Savings (net of tax) 3) Calculate Salvage Value (net of tax) 4) Add inflows from Annual Savings + Tax Shield + Salvage value 5) Multiply by discount rate **If annual savings is constant use OA / if not use PV of $1 6) Subtract outflow --> Inflow = if positive ACCEPT. |
|
|
Objective of IRR?
|
IRR is expected rate of return of a project.
"Time adjusted rate of return" |
|
|
How to solve IRR?
|
1) Determine life of the Asset
2) Calculate Payback Period: Net incremental investment / Net annual cash flows 3) Find Proper PV Table 4) Use your U/L and PP to find IRR |
|
|
Disadvantages of IRR
|
- Unreasonable reivestment assumption: assumed to reinvested at IRR, but that is difficult to predict if it will reach the IRR
- Inflexible Cash Flow Assumption: IRR is less reliable than NPV b/c when there are several alternating periods of net cash inflows and net cash outflows or the amounts of the cash flows differ significantly - Evaluates only based on interest rates |
|
|
What is Capital Rationing?
|
when you have a LIMITED CAPITAL:
You rank projects b/t: 1) Importance 2. Ranking and Acceptance: managers will allocate capital to the combination of projects with max NPV |
|
|
How to calculate Profitability Index?
|
Reverse of PP:
PV of net future cash flow / PV of net initial investment "Excess present value index" "Present Value Index" It it is +1 = good Means the that PV of inflows is greater the the PV of outflows |
|
|
Three types of Risk Preferences
|
1) Risk - Indifferent
2) Risk - Averse 3) Risk - Seeking |
|
|
Attributes of Risk - Indifferent
|
Increase in risk would NOT increase required rate of return
|
|
|
Attributes of Risk - Averse
|
Increase in risk would increase required rate of return
|
|
|
Attributes of Risk - Seeking
|
Increase in risk would DECREASE required rate of return
|
|
|
Diversifiable vs. Nondiversifiable Risk
|
Diverse: non-market / unsystematic / firm specific: risk can be eliminated by diversification
Non-Diversifiable: Market/Systematic Risk Cannot be eliminated through diversification |
|
|
Disadvantages of IRR
|
- Unreasonable reivestment assumption: assumed to reinvested at IRR, but that is difficult to predict if it will reach the IRR
- Inflexible Cash Flow Assumption: IRR is less reliable than NPV b/c when there are several alternating periods of net cash inflows and net cash outflows or the amounts of the cash flows differ significantly - Evaluates only based on interest rates |
|
|
What is Capital Rationing?
|
when you have a LIMITED CAPITAL:
You rank projects b/t: 1) Importance 2. Ranking and Acceptance: managers will allocate capital to the combination of projects with max NPV |
|
|
How to calculate Profitability Index?
|
Reverse of PP:
PV of net future cash flow / PV of net initial investment "Excess present value index" "Present Value Index" It it is +1 = good Means the that PV of inflows is greater the the PV of outflows |
