Capital Budgeting: Understanding Long-Term Project Investments, Quizzes of Business Management and Analysis

Download Capital Budgeting: Understanding Long-Term Project Investments and more Quizzes Business Management and Analysis in PDF only on Docsity! TERM 1 What is capital budgeting? DEFINITION 1 Analysis of potential projects. Long-term decisions; involve large expenditures. Very important to firms future. How can I come up with the money (thru debt/equity) TERM 2 Steps in Capital Budgeting DEFINITION 2 Estimate cash flows (inflows & outflows). Assess risk of cash flows. Determine r = WACC for project. Evaluate cash flows. TERM 3 examples of Capital Budgeting Project Categories DEFINITION 3 Replacement to continue profitable operations Replacement to reduce costs Expansion of existing products or markets Expansion into new products/markets Contraction decisions (can actually make money on) Safety and/or environmental projects (costs company) Mergers TERM 4 Independent vs. Mutually Exclusive Projects DEFINITION 4 independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other. TERM 5 what to know: NPV Method DEFINITION 5 Calc method easier Better than all 5 methods NPV = PV inflows Outflows (Costs) Accept project if NPV > 0. Negative NPV= bad project Choose between mutually exclusive projects on basis of higher positive NPV. Adds most value. TERM 6 define: NPV DEFINITION 6 amount of dollars we earn on project AFTER cost of capital is covered TERM 7 Using NPV method, how do we find which projects should be accepted? DEFINITION 7 If projects are mutually exclusive, accept higher NPV If projects are independent, accept both if NPV > 0. TERM 8 T/F: NPV is dependent on cost of capital. DEFINITION 8 TRUE, VERY TRUE TERM 9 T/F: If IRR > WACC, then the projects rate of return is greater than its cost DEFINITION 9 True we want this TERM 10 Using IRR method, how do we find which projects should be accepted? DEFINITION 10 If projects are independent, accept both if IRRS > r If projects are mutually exclusive, accept higher IRR IRR is not dependent on the cost of capital used. TERM 21 Why use MIRR versus IRR? DEFINITION 21 MIRR correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR. TERM 22 define: MIRR DEFINITION 22 The discount rate that causes the PV of a projects terminal value (TV) to equal the PV of costs. TERM 23 define: profitability index (PI) DEFINITION 23 The present value of future cash flows divided by the initial cost. It measures the bang for the buck. TERM 24 how to find PI on calc DEFINITION 24 CFo ALWAYS 0 Solve for NPV Take NPV and divide it by Initial Investment TERM 25 define: Payback period DEFINITION 25 The number of years required to recover a projects cost, OR how long does it take to get the businesss money back? TERM 26 T/F: payback period ignores Time Value of Money DEFINITION 26 True TERM 27 strengths vs. weakness of payback period DEFINITION 27 Strengths: Provides an indication of a projects risk and liquidity. Easy to calculate and understand. Weaknesses: Ignores the TVM. Ignores CFs occurring after the payback period. No standard of acceptable payback. TERM 28 describe: discounted payback period DEFINITION 28 Discount each period cash flows by: PV=FV/(1+r)^n TERM 29 Normal vs. Nonnormal Cash Flows (remember chart) DEFINITION 29 Normal Cash Flow Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Nonnormal Cash Flow Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. For example, nuclear power plant or strip mine. TERM 30 When there are Nonnormal CFs and more than one IRR, what do we do? DEFINITION 30 Use MIRR TERM 31 how do we compare NPV's of unequal periods? DEFINITION 31 Replacement Chains Equivalent Annual Annuity Approach (EAA) TERM 32 T/F: A projects engineering life does not always equal its economic life. DEFINITION 32 True TERM 33 Choosing the Optimal Capital Budget DEFINITION 33 Finance theory says to accept all positive NPV projects. Two problems can occur when there is not enough internally generated cash to fund all positive NPV projects: An increasing marginal cost of capital. Capital rationing TERM 34 what happens with: Increasing Marginal Cost of Capital or (external raised capital) DEFINITION 34 Large flotation costs, which increase the cost of capital. Investors often perceive large capital budgets as being risky, which drives up the cost of capital. If external funds will be raised, then the NPV of all projects should be estimated using this higher marginal cost of capital. TERM 35 define: Capital rationing DEFINITION 35 When a company chooses not to fund all positive NPV projects.