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capital budgeting criteria
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Advantages of NPV
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WGU D076 Unit 6

Finance Skills for Managers - Financial Decision Making

QuestionAnswer
capital budgeting criteria Metrics and calculations used to determine whether a project or asset will add value and be a worthwhile investment.
Advantages of NPV Considers time value of money Calculates value added to the firm Considers risk and required return
Disadvantages of NPV Requires calculation of appropriate cost of capital (difficult to estimate the cost of capital of a project) Is not useful to compare projects of varying sizes
What indicates to a firm that a project will increase shareholder wealth? The NPV is positive. The NPV is an estimate of the dollar amount that would be added to the firm’s value as a result of the investment.
What part of the NPV calculation is very important but difficult to estimate? The cost of capital. The cost of capital is affected by several things, such as different capital structures, timing of cash flows, and investment potential, which makes it difficult to calculate.
internal rate of return (IRR) The rate of return that a firm earns on its capital projects. (is the return on the investment of a project as a percentage.)
IRR internal rate of return
Advantages of IRR is easy to interpret, considers time value of money, and does not require use of required rate of return.
Disadvantages of IRR is not a good indicator of the amount of value created, ignores mutually exclusive projects, assumes reinvestment at the IRR rate, cannot be used to compare projects with different durations, and requires conventional cash flows.
capital-constrained environment when a limited about of funds are available
mutually exclusive When two or more events do not coincide.
profitability index (PI) The ratio of payoff to investment for a proposed project. (is the ratio of discounted benefits to discounted costs.)
Advantages of PI Considers the time value of money Takes into account the risk of future cash flows through the cost of capital Includes all future cash flows Indicates whether an investment will create value for the company
Disadvantages of PI requires calculation of cost of capital and is not useful for mutually exclusive projects.
Which capital investment evaluation method is presented as a ratio? Profitability index (PI)
How does the PI aid in interpretation of the NPV? It gives an idea of the return generated by a project.
Should a firm accept a project that has a PI of 0.8? Why? No, because the project would be generating cash inflows that are 20% short of the initial investment. Correct! As a rule, firms should accept only projects that have a PI greater than 1.
fixed-income securities Another name for bonds; a financial security in which the borrower pays a fixed interest payment to investors each year.
coupon rate The stated interest rate of a bond; also known as coupon yield.
par value The sum of money that a corporation promises to pay at the expiration of a bond; also called face value.
face value The sum of money that a corporation promises to pay at the expiration of a bond; also called par value.
bond indenture A legal contract that governs the relationship between a firm and its bondholders.
coupon yield The stated interest rate of a bond; also known as coupon rate.
maturity date The date at which a bond expires.
yield to maturity (YTM) is the rate of return that investors receive on a bond if they purchase a bond today at the market price and hold it until it matures. This is the required rate of return investors demand given the maturity and risk of the bond.
covenants Statements in a bond indenture that outline things the company will obligate itself to do or not do in order to protect bondholders.
Affirmative covenants A bond covenant that describes things the company pledges itself to do in order to protect bondholders.
Negative covenants A bond covenant that describes things the company pledges itself not to do in order to protect bondholders.
default Failure to meet a debt obligation.
premium bond A bond whose price is above its par value.
par bond A bond whose price is exactly equal to its par value.
discount bond A bond whose price is below its par value.
market capitalization The current market value of a publicly traded company’s total outstanding shares, indicating the size of a company.
Common stock represents equity, or ownership, in a firm
board of directors A group of people who jointly supervise the activities of an organization.
corporate governance The system of rules, practices, and processes by which a firm is directed and controlled.
Preferred stock A hybrid security that has no fixed maturity, has fixed payments, and does not confer voting rights on bondholders.
hybrid security A security that has some elements that resemble equity and others that resemble debt.
dividends in arrears A feature of preferred stock specifying that if a company ignores preferred stock dividends, it cannot pay anything to its common stockholders.
cumulative A feature of preferred stock specifying that if a company skips payment of a preferred stock dividend one year, it is still required to pay that dividend sometime in the future before paying any common dividends.
Capital investment The sum of money invested in a business to purchase long-term assets to further its objective of maximizing owner wealth.
Why might a firm seek capital investment? To purchase long-term assets for future growth
Intrinsic Value The value of an asset as determined through fundamental analysis without referring to the asset’s market value.
perpetuity model A formula used to value preferred stock that is based on the calculation of a perpetuity.
Gordon growth model A formula used to value common stock based on the assumptions that dividends are paid every year and grow at constant rate forever.
dividend discount model A model used to evaluate common stock that calculates the value of a share of common stock today by taking the present value of future dividend cash flows.
aggressive assets Companies or securities with beta greater than 1.
defensive assets Companies or securities with beta less than 1.
capital asset pricing model (CAPM) A model used to determine the risk-return relationship for an asset.
Capital budgeting The process of evaluation and planning for purchases of long-term assets.
Which method should you use to calculate a bond value? The PV function in Excel
You are evaluating a common stock. What is a key assumption for this evaluation? The growth rate is assumed to stay the same forever.
What is the name for the process of evaluating and planning for purchases of long-term assets? Capital budgeting
Criteria to Consider for Capital Investment It includes all cash flows that occur during the life of the project. It considers the time value of money. It incorporates the cost of capital—or in other words, the required rate of return on the project.
How can having more debt benefit a company? Interest expense on debts is paid before taxes are calculated.
incremental cash flows Cash flows that result from accepting a project. (Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project)
Incidental cash flows are one specific type of incremental cash flow that you need to include in your project evaluation.
cannibalization The reduction in sales of a company’s own products due to introduction of another similar product.
sunk costs A cost that has already been incurred and cannot be recovered.
Opportunity Cost any assets—such as land, cash, equipment, or even time—for a certain project implies the loss of the ability to use that same asset toward the next best project
How does allocated overhead affect the selection of capital investment projects? These cash flows are not a direct result of a specific project but are a general cost to the firm.
How are non-incremental cash flows different from incidental cash flows? are indirect cash flows that are not explicitly revenues or costs. Nevertheless, they must be included in the analysis.
Created by: mschelle816
 

 



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