FINANCE EXAM 4

businesses

• buy and sell econ assets

• Resource markets → business → product markets 

• Measuring econ profit = are you actually better off/have worth 

• Capital budgeting decision 

capital budgeting process

• Develop long term goals 

• Screen investments

• Evaluate investments

• Implement project 

• Control life of project

• Audit - how did project go/improve

econ methods take into account

• Cash flow 

• Time value 

• Opp cost

econ evaluation methods

• NPV 

• IRR

• PI 

• ^^ these show if its a good deal or bad deal 

NPV

• Npv of project adds value to company 

• Measures wealth creation of project

IRR

• Percent measure of the project’s rate of return

•  Accept if IRR > RRR

• Reject if IRR < RRR

PI

• profitability index

• Ratio that measures the NPV per dollar invested 

• Esp helpful when capital is tight 

• PI = PVinflows/PVoutflows 

• Accept if PI is greater than 1 

• Reject if PI is less than 1 

traditional decision methods

• Capital budgeting rules developed before modern financial analysis 

• Payback 

• Average accounting return 

payback

• Amount of time it takes for a project to pay back its investment when the project becomes profitable 

• Jills project payback is 4 yrs vs jacks project payback is 2 yrs 

  • Jack is better 

payback decision rule

• Managers set max payback period 

  • Payback less than max = accept 

  • Payback greater than max = reject 

  • If things are changing, technology, etc. → payback will usually be short 

  • If things are stable → payback will be usually be longer 

payback advantages

• Simple 

• Focuses on getting investment back 

payback disadvantages

• May ignore some cash flows 

• Does not use time value 

• No recognition of risk 

• Not good for big projects; good for small projects 

AAR

• average accounting return

• Rate of return after taxes and depreciation 

• Rate of return earned on a project 

• AAR = average net income/average book value 

AAR decision rule

• Managers determine the min acceptable AAR 

  • If project earns more than min = accept 

  • If project earns less than min = reject 

AAR advantages

• Info available 

  • Required by regulation 

  • Comparable 

• Focuses on profitability 

AAR disadvantages

• Does not reflect project econ value 

  • Does not use cash flows

  • Does not use time value 

  • No recognition of risk 

TMI cerebral stimulator

• Equals average investment 

• Average investment = beginning + ending/2

indep or mutually exclusive projects

• For ex: buying a vehicle = mutually exclusive 

  • Decision based on: 

    • Rank according to desirability 

    • Select only highest ranked alt

    • Let NPV guide decision (which ever one has higher one is better)

mutually exclusive

• IRR and NPV may give conflicting advice 

• Modified and new 

modified product

• Modification of an existing product 

• Consumers already know = easy switch = big cash flow comes fast 

new product

• New product that would take longer to get established, but eventually be successful 

• New consumers = takes awhile = big cash flow comes later 

capital rationing

• Firms total investment budget is limited to less than that required to take on all positive NPV projects 

• Occurs when company has limited capital and cannot take on all wealth increasing projects 

• Must rank projects and choose best projects given capital constraint

soft rationing

• Limits on investment

• Manage growth = “growth can kill”

• Existing owners want to keep control 

hard rationing

funds are not available and managers must choose the “best” projects from among all available projects 

project objective

• Maximize NPV of total investment budget

• Decision rule = select combo of projects that do not exceed capital budget

• Indivisible vs divisible 

econ independent projects

ones when making one choice is independent of other choices 

mutually exclusive

• Choosing from among alt and can only pick best one 

• Involves ranking process

ranking decision

managers must rank projects in order of desirability, pick best projects, stop when out of capital

rules for capital budgeting

• Include only cash flows 

• Factor econ interdependencies 

• Includes all opp costs 

• Exclude sunk costs

• Include impact of taxes 

capital budgeting decision

• Project cash flow = cash flow of firm 

• Project cash flow = OCF - capital spending - additions to NWC 

terminal cash flows

• Capital spending 

• Additions to NWC 

rules for capital budgeting

1. Include cash flows and only cash flows in calculations 

2. Include impact of project on cash flows from other product lines

3. Include all opp costs 

4. Forget sunk costs

5. Include only after tax cash flows in cash flow calculation

incremental cash flows

consist of all changes in the firm’s future cash flows that are a direct consequence of adopting a project 

econ interdependencies

occur when project would change the cash flows in other parts of the company; occur when project decreases the cash flows in other parts

capital budgeting projects

• Revenue enhancing projects = introduce new proj or improve existing product 

• Cost reduction projects = focus on reducing costs 

• Corporate social responsibility 

• Regulatory requirements

incremental cash flows after taxes

periodic cash outflows and inflows that occur if investment project is accepted 

operating cash flow

earnings before interest plus depreciation minus taxes

additions to net working capital

investments in projects short term assets

cost of capital

• = cost of debt + cost of equity 

• Aka discount rate 

• Rate of return required by investors

capital structure

mix of debt and equity capital maintained by company

WACC

• weighted average of cost of each capital component of levered firm

• Average cost of common equity, preferred stock, debt 

• Weights are the proportion of debt and equity used by firm 

• Can be used as discount rate 

• Project should at least earn avg cost of capital used to finance the project

firm value

• = value of equity and debt 

  • V = E + D

equity cost of capital

The more risk you have = higher rate of return

cost of debt capital

• There's always risk 

• Take tax deductibility of debt into account 

biases in WACC

• Great tool 

• Does not fit in all cases 

• Firm that uses one discount rate for all projects may over time increase risk of firm while decreasing its value 

• Managers should use market determined opp cost that reflects operating and financial risk of project 

  • Average discount rate is OK projects match firm’s existing risks 

  • Project specific discount rates should be used if project risks differ