Finance Exam #5

Payback Period

Tells us the # of years required to recover the initial investment.

Advantages of using the payback method.

• Easy to calculate and understand.
• Emphasizes liquidity.

Disadvantages of using the payback method.

• Does not consider time value of money/cost of capital

• Not consistent with firm goal of wealth maximization

Net Present Value (NPV)

The difference between the present value of the cash inflows and cash outflows

NPV Formula

PV of Future Cash Flows + PV of Initial Outlay

If NPV is positive, then you should _____

Accept

If NPV is negative, then you should _____

Reject

Profitability Index (PI) Formula

The total PV of the future cash flows (NPV)/ the initial outlay (or investment).

If PI is positive, then you should _____

Accept.

If PI is negative, then you should _____.

Reject.

If PI is positive,

1. NPV is positive.

2. PV of my future cash flows will be greater than the investment.

3. IRR is greater than my discount rate.

Internal Rate of Return (IRR)

The return on the firm's invested capital.

IRR Formula Components

IRR is the discount rate that equates the present value of the cash inflows with the present value of the cash outflows.

If IRR > cost of capital, then you should.

Accept.

If IRR < cost of capital, then you should

Reject.

What is important to know about IRR and the multiple sign change issue?

If there are multiple sign changes in the cash flow stream, we could get multiple IRRs.

When IRR = Rate of Return

NPV = 0

When you change the required rate of return, the IRR ______

Does NOT change.

Why was MIRR developed?

MIRR was developed to eliminate the problem of multiple IRRs (due to multiple sign changes).

What are the key differences between IRR and MIRR?

1. IRR assumes that all cash flows are reinvested at the IRR

2. MIRR provides a rate of return measure that assumes a cost of borrowing rate for cash outflows and a rate of return earned on positive cash flows.

If MIRR > cost of capital, , then you should ____

Accept.

If MIRR < cost of capital, , then you should ____

Reject.

Mutually exclusive projects

Cannot take on all projects, so you have to rank these by picking the largest NPVs or by sorting IRRs.

What is EAC helpful for?

EAC is helpful with mutually exclusive things with unequal lives.

Incremental cash flow

The difference between the cash flows with the project and without the project.

Are cash flows or accounting profits used?

Cash flows.

Synergistic effects

The effect on the cash flows of other projects.

Positive synergies

Adds additional revenue from additional 'existing' units (positive cash flow)
Less variable costs associated with additional units (negative)

Negative synergies

Cash Flow Diverted from Existing Products (revenue cannibalization).

Example of negative synergy

Cocoa pebbles being developed and taking away from the sales of fruity pebbles.

Are sunk costs incremental cash flows?

No

What is an example of a sunk cost

A market study that you've already completed; you ignore this for the free cash flow.

Opportunity costs

Passing up the next best alternative.

Example of an opportunity cost

Let's say I could lease a open space of mine, but I decide to use it, instead; I am passing up that rent.

What do you always ignore for free cash flows?

Interest payments and other financing costs

Working Capital =

Current Assets - Current Liabilities

Examples of Current Assets

• Cash
• Inventory
• A/R

Example of Current Liability

• Accounts Payable