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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
capital budgeting
the present value of all future cash flows of the project minus the cost of implementing it
net present value
list 4 commonly used methods for capital budgeting
net present value
internal rate of return
payback period
profitablility index
a ___ means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.
positive NPV
if NPV > 0 ...
ACCEPT
if NPV < 0 ...
REJECT
the interest rate that makes the NPV equal to zero
IRR
list 3 qualities about IRR
- 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
a pre-specified level to compare to IRR
hurdle rate
if IRR > hurdle rate...
accept
if IRR is < hurdle rate..
reject
___ measures the profitability of a project
IRR
the __ is determined by the market and is the standard hurdle rate
opportunity cost of capital
the IRR rule will give the same answer as the NPV rule as long as...
the NPV of a project declines smoothly as the discount rate increases
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
borrowing, (financing)
____ evaluates a project based on the number of years needed to recover the initial outflow for a project
payback period rule
advantages of payback period rule include
-easy to understand
-adjusts for uncertainty of later cash flows
-biased towards liquidity
-maybe useful for small scale investment
disadvantages of payback period rule
- 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
the time it takes to make the discounted cash flows sum up to the original investment
discounted payback period
advantages of discounted payback period
takes into account the time value of money

does not accept negative NPV investments
disadvantages of discounted payback period
ease of PB rule is lost
may reject positive NPV projects
NPV is best rule because
it maximizes expected wealth
always discount ____ never discount accounting profits
cash flows
the cash flow that should be included in a capital budgeting analysis are those that will only occur if the project is accepted
incremental cash flows
5 important points to remember with incremental cash flows
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
positive NPV is plausible only if it has one of these competitive advantages:
-first entry advantage
-proprietary technology
-product cost advantage
-contractual advantage
-good reputation and established customer list
analyze the change of the profitability of the project when only one variable is changed at a time
sensitivity analysis
project analysis given a particular combination of assumptions
scenario analysis
estimation of the probabilities of different possible outcomes from an investment project
simulation analysis