Financial Decision Making Final Review

Chapter 12 – Capital Budgeting Decision

• Capital Budgeting: Evaluating and choosing long-term investments to maximize shareholder wealth.

Types of Projects

• Independent Projects: Unrelated projects where accepting or rejecting one doesn't affect the others.

• Mutually Exclusive Projects: Competing projects; choosing one means not choosing another.

Financial Situations

• Unlimited Funds: Firm accepts all independent projects with acceptable returns.

• Capital Rationing: Limited funds, leading projects to compete for investment dollars.

Best Evaluation Techniques

• Must consider time value of money and the risk-return trade-off.

Standard Cash Flow Projects

• Cash Flow Structure: Initial outflow followed by inflows from the project.

Capital Budgeting Metrics

1. Net Present Value (NPV):

   • Formula: $NPV = ext{PV of Cash Flows} - ext{Initial Investment}$

   • Decision: Accept if NPV > 0.

2. Profitability Index (PI):

   • Formula: $PI = rac{ ext{PV of Cash Flows}}{ ext{Absolute Value of PV of Initial Cash Outflow}}$

   • Decision: Accept if PI > 1.

3. Internal Rate of Return (IRR):

   • Definition: Rate that makes NPV = 0.

   • Decision: Accept if IRR > WACC (Weighted Average Cost of Capital).

4. Payback Period:

   • Definition: Time taken to recover initial investment.

   • Decision: Accept if within a designated time frame.

   • Limitations: Ignores cash flows after payback, does not account for risk.

Relationship Between NPV, IRR, and PI

• For a standard cash flow project:

  • Positive NPV: IRR > Cost of Capital, PI > 1.

  • Negative NPV: IRR < Cost of Capital, PI < 1.

Multi-Factor Comparisons – Mutually Exclusive Projects

• NPV: Best for decision-making without capital constraints.

• PI: Helps sort projects under capital limits.

• IRR: Not suitable for mutually exclusive comparisons due to reinvestment assumptions.

Economic Value Added (EVA)

• Formula: $EVA = ext{EBIT} imes (1-t) - ext{WACC} imes ( ext{Interest Bearing Debt} + ext{Equity})$

Chapter 9 – Making Capital Investment Decisions

Identifying Relevant Cash Flows

• Only incremental cash flows matter.

Components of Cash Flows

1. Initial Cash Investment: Total cash outlay at time zero including purchase/install costs and tax implications.

2. Operating Cash Flows: Incremental revenues minus expenses during project life.

3. Terminal Cash Flows: Cash flows at project's end, including proceeds from selling assets and recovering working capital.

Additional Cash Flow Concepts

• Sunk Costs: Past costs; irrelevant for new decisions.

• Opportunity Costs: Potential gains from alternative uses of assets; relevant to analysis.

• Depreciation Recapture: Portion of sale price above NBV but under initial cost.

Chapter 8 – Current Asset Management

Working Capital

• Definition: Difference between current assets and current liabilities.

• Trade-off: Higher working capital means less risk but lower profitability.

Operating Cycle and Cash Conversion Cycle

• Average Collection Period: Time to collect receivables.

• Average Inventory Holding Period: Days items are in inventory before sale.

• Cash Conversion Cycle: Time it takes to convert investments in inventory to cash flows from sales.

Accounts Receivable - Credit Policies

• Trade Credit: Given by corporations; managing credit risk is vital.

5 Cs of Credit

1. Character: Borrower's repayment history.

2. Capacity: Ability to repay.

3. Capital: Amount of equity.

4. Collateral: Assets for securing borrowing.

5. Conditions: Economic environment affecting repayment.

Chapter 18 – Dividend Policy

Payout Policy Goals

1. Maximize shareholder value.

2. Retain sufficient funds for growth.

3. Signal future earnings to investors.

Dividend Payment Procedures

1. Declaration Date: When dividend is declared by the board.

2. Ex-Dividend Date: Date before which shareholders must own shares to receive a dividend.

3. Date of Record: When eligibility for dividends is determined.

4. Payment Date: Actual date of dividend distribution.

Share Repurchase Procedures

• Open Market: Buy shares back from the market.

• Tender Offer: Offer fixed price to buy back shares.

• Dutch Auction: Shareholders offer sale prices, all sold shares receive clearing price.