BFIN300 Final

The most fundamental capital budgeting decisions to be made are ____.

what services to be offered, what markets to compete in, determining what will be profitable.

An investment is worth undertaking if it ___.

 it creates value for its owners.

Net Present Value

The difference between an investment’s market value and its cost.

Capital budgeting decisions become substantially more difficult when ____.

there are no comparable investments.

NPV is a ____ Decision

Binary; If NPV is positive, we accept investment; if negative, we do not. 

Payback Period

The amount of time required for an investment to generate cash flows required to recoup investment costs. 

Payback Rule

An investment is acceptable if its payback period is less than a pre-specified number of years.

Payback Rule Pros & Cons

• Payback Rule cons: No discounting, arbitrary time period

• Payback Rule pros: Many decisions do not warrant a detailed analysis, easy and simple for short-term investments.

Discounted Payback Rule

If discounted payback is less than pre-specified number of years, investment is accepted.

• This method is rarely used in practice because it is no simpler to use than NPV, and cutoff is still arbitrarily set (could be too short).

Average Accounting Return

Average net income divided by Average Book Value.

• If the business has a target AAR of a certain targeted %,  the investment is acceptable.

Average Accounting Return Drawbacks

Not a rate of return in an economic sense, lack of an objective payback/cutoff period, does not consider cash flow or market value.

Internal Rate of Return (IRR)

Single rate of return that summarizes the merits of the project. The discount rate that makes the net present value equal to 0. The only way to find the IRR is through trial and error. 

Internal Rate of Return Pros & Cons

• Cons: May lead to incorrect decisions in comparisons of mutually exclusive projects. 

• Pros: Leads to identical decisions as NPV, people find it easier to discuss money in terms of return rates rather than $ amount.

Profitability index

the ratio between the present value of future expected cash flows and the initial amount invested in the project.

If a project has a positive NPV, the profitability index will be >1.

Why isn’t only NPV used?

NPV’s cannot be observed in the market and need to be estimated. Because of the possibility of poor estimation, financial managers use different criteria to evaluate.

____ are the key element to discounted cash flow.

Projected Cash Flows

Relevant cash flows are determined and defined in terms of _____.

increments

Incremental cash flows

consists of any and all changes of a business’s future cash flows that are a direct consequence of taking on a project.

Issues with Incremental cash flow

• Sunk Costs: Costs that have already occurred and can’t be removed, shouldn’t be considered as relevant costs. 

• Erosion: Cash flows from a new project coming at the expense of a businesses existing projects.

• Net Working Capital: The businesses investment in NWC resembles a loan, easy to overlook the importance of these investments.

• Not including financing costs.

When evaluating a project, first we must create a ____.

pro forma financial statement (statement that projects future years operations of project under consideration.)

Relevant Cash Flow

 Cash flows that are a direct consequence of taking on a project.

After we double-check calculations for discounted cash flow, we make sure ___.

NPV is positive.

Just because NPV is positive doesn’t mean the project is worth taking on, just that ___.

it is worth further consideration.

Forecasting Risk

Errors associated with predicting future cash flows that could mislead managers to take on a project.

Positive NPV are ___ in a highly competitive environment

Rare; # of the projects are limited to take on because funding is scarce. 

Upper/Lower Band

the range of expected outcomes for a given financial metric, such as revenue or expenses. The upper band indicates the most optimistic scenario, while the lower band shows the most pessimistic scenario.

If the worst case scenario results in a positive NPV, we will ____.

have more confidence to invest.

If most scenarios are negative, then there is a _____.

a higher forecasting risk associated with the project.

Scenario Analysis

All relevant variables change to take on a few different values to assess the potential impacts on the project's outcomes.

Sensitivity Analysis

Investigating what happens to NPV when only one variable is changed. Pinpoint areas where forecasting risk is high/low. 

The most important variable in simulation analysis is often ___.

Sales Volume

Break-even analysis

Relationship between sales volume and profitability.

The most used measure of Break-even is ___.

Accounting break-even: The sales volume that results in 0 net income.

• Similar to the payback period rule

Operating Leverage

The degree to which a business or a project relies on fixed costs. 

Capital Rationing

Business has possible investment with positive NPV but it can’t access funds to invest in the project.

Soft Rationing

A business cannot finance a new project due to its own policies. 

Hard Rationing

A business cannot raise financing for a project under any circumstances. 

Required ROI depends on ___.

an investment's risk.

• the greater the risk the greater the required return. 

ROI 2 Components

Income & Change in Value.