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FIN250 Exam #3

Study cards for the third exam.

QuestionAnswer
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