Finance Final Ch. 10

Front 1

What does Capital Budgeting deal with?

Ch. 10

Back 1

It deals with the evaluation of investment projects.

Front 2

Why is Capital Budgeting important?

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Back 2

1. Long lasting impact
2. Involves substantial expenditures
3. Defines the firm's strategic direction

Front 3

What is the process of Capital Budgeting?

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Back 3

1. Estimate project costs
2. Estimate project cash flows including salvage value
3. Estimate the risk of the projected cash flows
4. Determine the cost of capital (discount rate)
5. Value the project using one of the following decision rules: Payback period, Net Present Value (NPV), Internal Rate of Return (IRR), or Profitability Index (PI)
6. Compare #5 to #1. If #5 > #1, the project should be undertaken - cost benefit analysis

Front 4

What is the Payback Period decision rule for Capital Budgeting?

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Back 4

It is the time until the initial investment in the project is recovered - measures liquidity.

1. Estimate project cash flows
2. Calculate payback period

Front 5

When do you accept a project under the Payback Period decision rule of Capital Budgeting?

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Back 5

Accept if Payback Period < Cutoff
Reject if Payback Period > Cutoff

Front 6

What is the Discounted Payback Period decision rule for Capital Budgeting?

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Back 6

The time until the sum of an investment's discounted cash flows equals its cost.

1. Estimate project cash flows
2. Discount each cash flow
3. Calculate payback period

Front 7

What are the advantages and disadvantages of using the Payback & Discount Payback Period decision rules for Capital Budgeting?

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Back 7

Advantages:
1. Stresses liquidity and risk
2. Simple, easy to use

Disadvantages:
1. Regular Payback ignores the TVM
2. Both Paybacks ignore cash flows beyond cut-off
3. Both Paybacks are biased toward short-term projects

Front 8

What is the Net Present Value (NPV) decision rule for Capital Budgeting?

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Back 8

An estimate of the value that a project brings to the firm. The difference between a project's market value and its cost (PV of all future cash inflows).

1. Estimate project cash flows
2. Estimate the opportunity cost of capital
3. Discount the cash flows

Front 9

When do you accept a project under the Net Present Value (NPV) decision rule of Capital Budgeting?

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Back 9

Accept if NPV > 0
Reject if NPV < 0

The higher the NPV, the better the project.

Front 10

What do positive, neutral, and negative NPV's mean?

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Back 10

1. Positive NPV means that the project is earning more than the opportunity cost of capital.
2. Neutral NPV (zero) means that the project is earning exactly the opportunity cost of capital.
3. Negative NPV means that the project is earning less than the opportunity cost of capital.

Front 11

What are the advantages and disadvantages of using the Net Present Value (NPV) decision rule for Capital Budgeting?

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Back 11

Advantages:
1. Always gives the "correct" answer
2. Relatively easy to use
3. Objective decision critera

Disadvantages:
None

Front 12

What does the Profitability Index (PI) decision rule for Capital Budgeting do?

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Back 12

Shows the return per dollar invested.

Front 13

When do you accept a project under the Profitability Index (PI) decision rule of Capital Budgeting?

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Back 13

Accept if PI > 1
Reject if PI < 1

The higher the PI, the better the project.

Front 14

What are the advantages and disadvantages of using the Profitability Index (PI) decision rule for Capital Budgeting?

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Back 14

Advantages:
1. Good for ranking projects under capital rationing.

Disadvantages:
1. Should only be used under capital rationing.

Front 15

What is the Internal Rate of Return (IRR) decision rule for Capital Budgeting?

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Back 15

The rate of the return that the project earns (The rate that makes the project's NPV equal zero).

1. Estimate project cash flows
2. Compute the IRR
3. Estimate the opportunity cost of capital (required return)

Front 16

When do you accept a project under the Internal Rate of Return (IRR) decision rule of Capital Budgeting?

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Back 16

Accept if IRR > firm's required return
Reject if IRR < firm's required return

Front 17

What are the advantages and disadvantages of using the Internal Rate of Return (IRR) decision rule for Capital Budgeting?

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Back 17

Advantages:
1. Gives a return

Disadvantages:
1. May give multiple IRR's (each change in the sign of the cash flows may produce a different IRR)
2. Doesn't work for mutually exclusive projects
3. May not always give the same answer as NPV
4. Assumes all project cash flows are reinvested at the IRR

Front 18

What is the Modified Internal Rate of Return (MIRR) decision rule for Capital Budgeting?

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Back 18

A rate of return that is a better indicator of relative profitability than IRR.

1. Estimate project cash flows
2. Estimate the cost of capital
3. Compute the PV of costs
4. Compute the FV of cash inflows
5. The discount rate that forces the PV of costs to equal the FV of cash inflows is the MIRR

Front 19

What are the advantages and disadvantages of using the Modified Internal Rate of Return (MIRR) decision rule for Capital Budgeting?

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Back 19

Advantages:
1. Gives a return like IRR
2. Assumes that project cash flows are invseted at the cost of capital, not the MIRR
3. Solves the multiple IRR problem

Disadvantages:
1. May not always give the same answer as NPV - especially when projects differ in size