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22 Cards in this Set
- Front
- Back
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What is capital budget? |
Process in which LT investments are generated, analyzed and undertaken. |
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What is the gal of the firm in capital budgeting? |
Goal of firm is always to maximize value - this does not mean maximizing profits. It means maximizing NPV of any project. |
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What are the three classifications of projects by type? |
1. Expansion 2. Replacement 3. Mandatory |
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What are expansion projects? |
Involve increasing a product line, improving productivity, etc. Most Risky. Improve firm's ability to market/produce products. |
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What are replacement projects? |
Replace assets that have become obsolete. E.g. purchase new computer system. Less Risky. |
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What are mandatory projects? |
Legislated by gov't or other regulators. E.g. pollution controls, retrofitting equipment. Often makes the cost irrelevant, not worth budgeting |
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What are the two classifications of project by relationship? |
1. Mutually Exclusive 2. Independent |
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What are mutually exclusive projects? |
Acceptance of 1 project precludes adoption of the 2nd. E.g. deciding between 2 computer systems or 2 call centre locations. |
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What are independent projects? |
Cash flows of two projects and decision to accept are unrelated. Proposal to upgrade a computer system is independent of building new call centre. May still be subject to capital rationing. |
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What are the four main methods of determining acceptance/rejection criteria for capital budgeting decisions? |
1. Payback Period/Discounted Payback 2. Net Present Value 3. IRR 4. Profitability Index |
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What is the payback method? |
The number of years it takes a firm to recover its initial investment. Discounted payback simply discounts cash flows by k before determining this period. |
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What is NPV? |
Using the firm's cost of capital, k, the NPV simply discounts all flows according to k and the year in which the flow occurs to present value. IF NPV > 0, firm has enough money to repay initial investment at return required by investors. Pos. NPV increases firm value. |
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What are the advantages of NPV? |
Take account of the firm's cost of capital, k. Uses all cash flows. Provides most consistent measure for ranking projects, since NPS is project's contribution to firm value. |
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What are the disadvantages of NPV? |
Cannot perform if firm k is unknown. Only an estimate of profitability. |
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What is the Internal Rate of Return (IRR)? |
IRR is the interest rate at which NPV is 0. If the project is a traditional project (neg. flows followed by pos. flows), then accept if IRR > k. If project is non-traditional, like a bank loan, then accept if IRR < k. |
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How do IRR and NPV compare? |
IRR and NPV will always give same decision for independent projects. Will not always give same results for mutually exclusive projects if the sizes of the projects are considerably different or timing of cash flows are different. |
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Why can IRR and NPV give different results? |
IRR assumes that intermediate flows can be reinvested at IRR. NPV assumes that intermediate flows can be reinvested at firm's opportunity cost of capital. |
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What is one disadvantage of IRR concerning "sign changes"? |
If a traditional project, neg. flows followed by pos, flows, has another period of negative flows, then IRR is useless. In other words, can only factor one sign change. |
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What is the Profitability Index? |
Ratio of the PV of future expected cash flows (excluding the initial investment) divided by the initial investment. Accept if PI > 1 for independent projects. |
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What are the advantages of the profitability index? |
Simple and easy to solve/explain. Uses all cash flows. Favours smaller projects, so bias towards lower risk. Will give consistent results to NPV for ind. projects. |
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What are the disadvantages of the profitability index? |
Cannot be used to rank mutually exclusive projects. Give greater ranking/preference to smaller projects. |
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What is a PV profile graph? |
PV profile graphs the PV of the project cash flows at different interest rates. LT projects more sensitive to rate changes, and are steeper. |
