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29 Cards in this Set
- Front
- Back
the process by which a firm uses a set of principles and rules to decide what investments to make within the firm
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capital budgeting
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the present value of all future cash flows of the project minus the cost of implementing it
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net present value
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list 4 commonly used methods for capital budgeting
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net present value
internal rate of return payback period profitablility index |
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a ___ means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
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positive NPV
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if NPV > 0 ...
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ACCEPT
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if NPV < 0 ...
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REJECT
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the interest rate that makes the NPV equal to zero
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IRR
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list 3 qualities about IRR
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- most important alternative to NPV
-often used in practice and is intuitively appealing -based entirely upon estimated cash flows and is independent of interest rates found elsewhere |
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a pre-specified level to compare to IRR
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hurdle rate
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if IRR > hurdle rate...
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accept
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if IRR is < hurdle rate..
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reject
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___ measures the profitability of a project
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IRR
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the __ is determined by the market and is the standard hurdle rate
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opportunity cost of capital
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the IRR rule will give the same answer as the NPV rule as long as...
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the NPV of a project declines smoothly as the discount rate increases
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when the cash flows are from a __ project, and the NPV is an increasing function of the discount rate, a lower return is more desirable
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borrowing, (financing)
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____ evaluates a project based on the number of years needed to recover the initial outflow for a project
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payback period rule
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advantages of payback period rule include
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-easy to understand
-adjusts for uncertainty of later cash flows -biased towards liquidity -maybe useful for small scale investment |
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disadvantages of payback period rule
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- the cutoff point is arbitrary
-ignores the time value of money -ignores cash flows beyond the cutoff date -biased against longterm projects -hard to choose among projects with same PB period |
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the time it takes to make the discounted cash flows sum up to the original investment
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discounted payback period
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advantages of discounted payback period
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takes into account the time value of money
does not accept negative NPV investments |
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disadvantages of discounted payback period
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ease of PB rule is lost
may reject positive NPV projects |
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NPV is best rule because
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it maximizes expected wealth
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always discount ____ never discount accounting profits
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cash flows
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the cash flow that should be included in a capital budgeting analysis are those that will only occur if the project is accepted
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incremental cash flows
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5 important points to remember with incremental cash flows
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1. include all indirect effects
2. ignore sunk costs 3. include opportunity costs 4. recognize the investment in working capital 5. beware of allocated overhead costs |
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positive NPV is plausible only if it has one of these competitive advantages:
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-first entry advantage
-proprietary technology -product cost advantage -contractual advantage -good reputation and established customer list |
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analyze the change of the profitability of the project when only one variable is changed at a time
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sensitivity analysis
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project analysis given a particular combination of assumptions
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scenario analysis
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estimation of the probabilities of different possible outcomes from an investment project
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simulation analysis
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