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15 Cards in this Set
- Front
- Back
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Four Steps of Capital Budgeting Process |
1) Generate investment ideas 2) Analyze project ideas 3) Create firm-wide capital budget 4) Monitor decisions and conduct a post-audit |
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Sunk Costs |
Costs that cannot be avoided even if the project is not undertaken - should not be included in capital budgeting analysis
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Externalities |
Effects the acceptance of a project may have on other firm cash flows
-cannibalization - when new project takes sales from existing product
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Unconventional Cash Flow Pattern |
More than one sign change in cash flows (from positive to neg or vice versa) |
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What costs should cash flows be based on in capital budgeting? |
Opportunity Costs - cash flows a firm will lose by undertaking the project under analysis |
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Payback Period |
Number of years it takes to recover initial cost of an investment - does not take into account TVM or cash flows beyond payback period -Useless as a measure of profitability -Good measure of project liquidity |
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Discounted Payback Period |
Uses PV of project's estimated cash flows -MUST BE GREATER THAN PAYBACK PERIOD -Still does not consider cash flows beyond payback period -Poor measure of profitability |
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Profitability Index |
Present value of a project's future cash flows divided by initial cash outlay PV of future cash flows / CF0 OR 1+(NPV / CF0) |
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Profitability Index Rule |
If PI>1, accept (this means NPV is positive) If PI<1, reject |
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NPV Profile |
Graph that shows a project's NPV for different discount rates -IRR will be discount rates where NPV profiles intersect x-axis |
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Crossover Rate |
Rate at which NPVs are equal on an NPV profile |
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How do you calculate crossover rate?
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Subtract cash flows of two projects and calculate IRR of the differences
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Key Advantage of IRR |
Measures profitability as a percentage, showing return on each dollar invested Provides information on margin of safety that NPV does not |
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Multiple IRRs or no IRR |
May occur when a project has unconventional cash flows |
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How to find expected change in stock price given NPV of project |
(NPV + market value of company prior to project) / # shares outstanding **However, if shareholders expect the project, there will likely be no change in share price |
