FIN 345 1st EditionExam # 5 Study GuideChapter 13 and 14Chapter 131. Ch 13 Objectives:a. Describe the relevant cash flows that must be forecast to make informed capital budgeting decisionsi. Replacement decisions: decisions about whether to purchase capital assets to take the place of existing assets so as to maintain existing operationsii. Expansion decisions: decisions about whether to purchase capital projects and add them to existing assets so as to increase existing operationsiii. Independent projects: projects whose cash flows are not affected by the acceptance or non-acceptance of other projectsiv. Mutually exclusive projects: a set of projects where the acceptance of one project means that other projects cannot be acceptedb. Describe the importance of capital budgeting decisions and the general process that is followed when making investment decisionsi. Steps in valuation process1. Determine the cost or purchase price of the asset2. Estimate the future cash flows expected to be generated by the asset3. Evaluate the riskiness of the projected cash flows to determine the appropriate rate of return to use for computing the present value of the estimated cash flows4. Compute the present value of the expected cash flows5. Compare the present value of the expected future cash flows with the initial investment or cost that is required to acquire the asset. Alternatively, the expected rate of return on the project can be calculated and compared with the firms required rate of return (WACC)c. Describe how the net present value technique and the internal rate of return technique are used to make investment decisionsi. Cash flows: the actual cash, as opposed to accounting profits, that a firm receives or pays during some specific periodii. Incremental cash flow: the change in a firm’s net cash flow attributable to an investment projectiii. Sunk cost: a cash outlay that already has been incurred and that cannot be recovered regardless of whether the project is accepted or rejectediv. Opportunity cost: the return on the best alternative use of an asset; the highest return that the firm will forgo if funds are invested in a particular projectv. Externalities: the way in which accepting a project affects the cash flows in other parts (areas) of the firmvi. Initial investment outlay: the incremental cash flows associated with a project that occur only at the start of a project’s lifeThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.vii. Supplemental operating cash flows: the changes in day to day cash flows that result from the purchase of a capital project and continue until the firm disposes of the assetviii. Terminal cash flow: the net cash flow that occurs at the end of the life of a project, including the cash flows associated with the final disposal of the project and the return of the firm’s operations to their state prior to the project’s acceptanceix. Net present value: a method of evaluating capital investment proposals by finding the present value of the net cash flows, discounted at the rate of returnrequired by the firmx. Internal rate of return: the discount rate that forces the present value of a project’s expected cash flows to equal its cost1. Required rate of return (hurdle rate): the discount rate that the IRR must exceed for a project to be considered acceptablexi. Traditional payback period: the length of time it takes to recover the original cost of an investment from the project’s expected cash flowsxii. Discounted payback period: the length of time it takes for a project’s discounted cash flows to repay the initial cost of the investmentd. Compare the NPV technique with the IRR technique and discuss why the two techniques might not always lead to the same investment decisionsi. Net present value profile: a curve sowing the relationship between a project’s NPV and various discount ratesii. Crossover rate: the discount rate at which the NPV profiles of two projects cross and therefore at which the projects NPVs are equaliii. Reinvestment rate assumption: the assumption that cash flows from a project can be reinvested at the cost of capital if using the NPV method or at the internal rate of return if using the IRR methodiv. Modified IRR: the discount rate at which the present value of a project’s cost isequal to the present value of its terminal value, where the terminal value is found as the sum of the future values of the cash inflows compounded at the firm’s required rate of returnv. Multiple IRRs: a project has 2 or more IRRse. Describe how the riskiness of a capital budgeting project is evaluated and how the results are incorporated in capital budgeting decisioni. Stand-alone risk: the risk that an asset would have if it were a firm’s only asset.It is measured by the variability of the asset’s expected rate of returnii. Corporate risk: the effect a project has on the total risk of the firm. It captures the risk relationships among the assets that the firm ownsiii. Beta risk: that part of a project’s risk that cannot be eliminated by diversificationiv. Scenario analysis: a risk analysis technique in which bad and god sets of financial circumstances are compared with a most likely or base case scenariov. Worst case scenario: an analysis in which all of the input variables are set at their worst reasonably forecasted valuesvi. Best case scenario: an analysis in which all of the input variables are set at their best reasonably forecasted valuesvii. Base case: an analysis in which all of the input variables are set at their most likely valuesviii. Project required rate of return: the risk-adjusted required rate of return for an individual projectix. Pure play method: an approach used for estimating the beta of a project in which a firm identifies companies whose only business is the product in question, determines the beta for each company, and then averages the betas to find an approximation of its own project’s betax. Risk adjusted discount rate: the discount rate that applies to a particular risky stream of cash flows. It is equal to the risk-free rate of interest plus risk premium appropriate to the level of risk attached to a particular project’s income streamf. Describe how capital budgeting decisions differ for firms that have foreign operations compared to firms that only have domestic operationsi. Earnings