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# FIN250 Exam #3

### Study cards for the third exam.

Question | Answer |
---|---|

NPV | = PV inflows - Cost = Net gain in wealth Advantages: Accounts for time value of money, risk of cash flows, indicates increase in value [[If positive, accept project.]] |

Discount Payback | Advantages: Includes time value of money, does not accept est. NPV investments when all future cash flows are positive, biased towards liquidity Disadvantages: May rejecct positive NPV investments, requires arbitrary cutoff point, biased against LT |

IRR | Most important alternative to NPV Advantages: Closely related to NPV, often leading to identical decisions Disadvantages: result in multiple answers or not deal with non-conventional cash flow [[Accept project if IRR is > return]] |

Profitability Index | = (PV of Future CF)/initial cost Advantages: Closely related to NPV Disadvantages: May lead to incorrect decisions in comparisons of mutually exclusive investments Ex: Int.Cst = 500 CF0=0, CF1=325, F01=2, I/Y=10, [CPT]NPV=564.04 /500 |

Independent Projects | Cash flows of one [[are unaffected]] by the acceptance of the other. |

Mutually Exclusive Projects | Cash flows of one [[can be adversely impacted]] by the acceptance of the other. |

Problems of IRR | IRR is unreliable in the following situations: *Non-convential cash flows *Mutually exclusive projects |

NPV vs. IRR | Conflicts: NPV directly measures the increase in value to the firm Whenever there is a conflict between NPV and another decision rule,, you should always use NPV. |

Common Types of Cash Flows | Incremental cash flows |

Cash Flow From Assets | = Operating Cash Flow - Net Capital Spending - Changes in NWC = OCF - NCS - dNWC |

Computing OCF w/ Different Methods | = (EBIT - Taxes) + Dep. = EBIT + Dep. - Taxes [[EBIT = Sales - Costs - Dep.]] [[Taxes = EBIT *t]] |

Computing Depreciation | Straight-Line: Dep. = (initial cost - sell value)/# of years |

After-tax Salvage | the salvage value is different from the book value of the assest, then there is a tax effect |

Depreciation tax shield | OCF = (Sales - Costs)(1-t) + Dep.*t (t = marginal tax rate) |

Project Cash Flow | Initial Outlay Int. Costs (CF0) Operating CF: OCF Forumla Terminal CF: NWC Recovery After tax salvage |

Cost-Cutting Projects | Use Tax Shield Approach (OCF formula) |

Break-Even Analysis aka Payback Period | Ex: 0, 1, [2], (2.4) 3 (years) CF: -100 10 60 100 [80] Cum: -100 -90 [-30] 0 50 Payback_L = 2 + (30/80) = 2.75 yrs Accept if the payback is less than preset limit. |

Fixed costs | Constant, regardless of output, over some period of time |

Variable Costs | Total Variable Costs = Qty * Cost Per Unit The cost to produce one more unit |

General Break-Even Expression | Q = (OCF + FC)/(P-v) Contribution Margin: (P-v) |

Accounting Break-Even | sales volume at which net income = 0 |

Cash Break-Even | sales volume at which operating cash flow = 0 |

Financial Break-Even | sales volume at which NPV = 0 |

Operating Leverage | The degree to which a firm or project relies o fixed costs. DOL = %Change in EBIT/%Change in Sales |

Capital Rationing | Occurs when a firm or division has limited resources |

Soft Rationing | the limited resources are temporary, often self-imposed |

Hard Rationing | capital will never be available for this project |

EAC Approach | Simply an annuity cash flow that yields the same present value as the project's NPV |

Replacement Chain Approach | Repeat projects using a replacement chain to equalize life spans. |

What is the payback period? | The time it takes to get the initial cost back in a nominal sense. |

Why do small businesses like to adopt payback period method? | Determines the acceptance of projects based on preset limit. |

What advantages does the discounted payback have over the ordinary payback? | Determines the acceptance of a project based on a discounted basis within a specified time. |

What does the profitability index measure? | Measures the benefit per unit cost, based on the time value of money. |

Under what circumstances will the IRR and NPV rules lead to the same accept-reject decisions? When might they conflict? | If independent and IRR > RR and NPV > 0, accept one or both. If mutually exclusive, IRR1 > IRR2 and NPV1 > NPV2, accept Project 1. (Cannot accept both) |

What are the potential problems using the IRR as a capital budgeting techniques? | For independent projects, yes. But not really for mutually exclusive projects. |

Profitability Index of a project is 1.0. What do you know about the project's net present value (NPV) and it's internal rate of return (IRR)? | Ex: A profitibility index of 1.1 implies that for every $1 of investment, we create an additional $0.10 in value. |

How does the net present value (NPV) decision rule related to the primary goal of financial management, which is creating wealth for the shareholders? | NPV is directly releated to the net gain in wealth, which given a positive value for indepedent projects would result in choosing both projects or being mutually exclusive choosing the projec with the higher NPV; adds most value. |

In a single sentence, explain how you determine which cash flows should be included in the analysis of a project. | Unconventional cash flows. |

In capital budgeting analysis, why do we focus on cash flow rather than accounting profit? | NPV and IRR are the most commonly used tools to determine whether or not value is being created for the firm; thus being based on cash flows rather than just accouting profits. |

Why might a financial manager be interested in the accounting break-even? | It gives an indication of how a project will impact accounting profit. |

If a project breaks even on an accounting basis, what do you know about its Payback, NPV and IRR? | Cash Flow = Dep. NPV < 0 IRR = 0 |

Created by:
Kruzil