Final Study Guide On the exam 5 rules MIR IRR and the theory of why one is good and why one is not good ie IRR Capital budgeting fixed variable depreciation working capital taxes Capital budgeting plus scenario analysis monte carlo simulation Risk analysis and real options discounted cash flow and such General questions like what is a switch option or if demand increased would it change value of project Capital structure three main theories MM w o tax MM with tax financial distress 4 equations to know with those Capital intensive not risky have a lot of cash means they have more debt Other theories signaling pecking order NOT DIVIDENDS Chapter 11 Vocab Capital budgeting the process of planning expenditures on assets with cash flows that are expected to extend beyond one year Strategic Business Plan a long run plan that outlines in broad terms the firm s basic strategy for the next 5 to 10 years Net Present Value NPV a method of ranking investments proposals using the NPV which is equal to the present value of the project s free cash flows discounted at the cost of capital Mutually Exclusive Projects a set of projects where only one can be accepted Internal Rate of Return IRR the discount rate that forces a project s NPV to equal zero Multiple IRRs the situation where a project has two or more IRRs Modified IRR the discount rate at which the present value of a project s cost is equal to the present value of its terminal value where the terminal value is found as the sum of the future vales of the cash inflows compounded at the firm s cost of capital Net Present Value Profile a graph showing the relationship between a project s NPV and the firm s cost of capital Crossover Rate The cost of capital at which the NPV profiles of two projects cross and thus at which the projects NPVs are equal Payback Period the length of time required for an investment s cash flows to cover its cost Discount Payback the length of time required fro an investment s cash flows discounted at the investment s cost of capital to cover its cost Decision rules in capital budgeting Payback Period Discounted Payback Period NPV and IRR Modified Internal Rate of Return The goal is to only do projects that increase firm value must recognize 1 time value of money and 2 incorporate all relevant free cash flows Look to avoid 3 arbitrary assumptions 4 need for data that has great uncertainty 5 excessive complexity of calculation 6 technical problems The Five Decision Rules Payback Period do project if total cash flow within the payback period required investment EX cost 1000 first year and receive 900 with 3 year payback period then it s a bad project Find payback period by adding up each of the 3 year cash inflows 900 In the fourth year you receive 700 dollars must use 100 of it to pay back the 1000 100 700 1429 so the payback period is 3 1429 years DO project if PV of the cash flows within the payback period the required investment EX use same cash inflows from above 1000 300 200 400 700 3 year discounted payback period calculation 300 1 1 200 1 1 2 400 1 1 3 738 54 1000 so BAD Project Find the discounted payback period 272 73 165 29 300 53 738 54 1 000 1 216 65 900 700 Period is between 3 and 4 years Amount left to be paid in year 4 1 000 738 54 261 46 Cash flow in year 4 478 11 Payback point in year 4 Discounted Payback period T NPV 261 46 478 11 0 5469 3 5469 years t 0 Ct 1 r t DO project if NPV is positive The NPV is the present value of all cash flows EX use the same cash flows as above 1 000 300 00 200 00 400 00 700 00 4 1 1 2 3 1 1 1 1 1 1 216 65 0 The result makes it a good project DO project if IRR required rate of return r IRR the discount cash flows equal to zero IRR s t 0 T t 0 C t IRR t 1 rate that makes present value of all including any required investments Modified Internal Rate of Return Rule DO project if MIRR required rate of return r MIRR is the discount rate that makes the PV of all cash flows equal to the PV of the terminal value Modification allows the reinvestment rate of cash flows to be specified and allows the reinvestment rate of cash flows to be different than the discount rate MIRR Steps 1 determine al cash flows 2 find terminal value the future value of all cash inflows 3 find the PV of all cash outflows 4 find the MIRR which is the discount rate that makes the PV of all ash outflows equal to the PV of the terminal value LEARN THE MIRR Undertake Projects when Payback Period payback period cash flow investment Discount Payback Period Discounted payback period cash flow investment NPV NPV 0 IRR IRR r MIRR MIRR r Assuming no technical problems occur NPV and IRR always give the same and the correct answer about whether or not to do one specific project BUT cannot compare projects NPV rule must be used to compare select projects Comparing Projects Comparing Projects Results IRRa 18 1 IRRb 29 6 NPVa 216 65 NPVb 53 36 In the end Project A increase firm value by 216 65 Project B increases firm value by 53 36 Project A is worth 163 29 more than B Sign Changes and Multiple IRRS 3 20 16 32 32 makes multiple correct answers IRR 7 or IRR 48 or IRR 437 Chapter 12 Vocab Incremental Cash Flow a cash flows that will occur if and only if the firm takes on a project Sunk Cost a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected Opportunity Cost the best return that could be earned on assets the firm already owns if those assests are not used for the new project Externality an affect on the firm or the environment that is not reflected in the project s cash flows Cannibalization the situation when a new project reduces cash flows that the firm would have otherwise had Stand Alone Risk the risk an asset would have if it were a firm s only asset and if investors owned only one stock It is measured by the variability of the asset s expected returns Corporate Within Firm Risk risk considering the firm s diversification but not stockholder diversification It is measured by a project s effect on uncertainty about the firm s expected future returns Market Beta Risk considers both firm and stockholder diversification It is measured by the project s beta coefficient Risk Adjusted Cost of Capital the cost of capital appropriate for a given project given the riskiness of that project The greater the risk the …