FIN3403 LECTURE GUNTER Wednesday October 8th 2014 1 Disclaimer These notes were prepared by a student enrolled in Melody Gunter s FIN3403 Fall 2014 course and were compiled for Exam 2 These notes contain all materials discussed during lecture on October 8th 2014 and aim to serve as a partial conceptual review for strictly Exam 2 Studying these notes alone will not guarantee you a passing grade It is highly recommended you combine the review of these notes with the review of notes from other lecture dates that you may have missed in addition to extensive practice using your TI BA II Plus on calculation problems Happy studying Capital Budgeting Recall that capital budgeting is one of three decisions a company must make Capital budgeting includes all of the decision making within the company that involve acquiring assets and investing in projects Is considered the most important decisions a company must consider o This is because good investments bring in more money for the company creates expansion within the company which in turn creates more value to shareholder Every company must decide what to do with their cash and cash equivalents Key things to think about when deciding whether or not to invest in a project o What are the cash flows o How big are the cash flows o What is the size of these cash flows relative to the initial investment o What is the timing of these cash flows o How risky are the cash flows How likely are they to happen o An important note Cash flows can be positive or negative Think of the initial investment as a negative cash flow or one in which we must give up cash in hopes of creating more inflows of cash later So whenever you see the term cash flows this can be money coming in from the project or money going out There are a few ways to analyze capital budgeting decisions o Of the different ways the Net Present Value NPV tool is the most effective and most important 1 Net Present Value NPV NPV represents how many dollars will be added to shareholder wealth from investing in a particular project more about NPV on the following page o Since the key goal of financial managers is to increase shareholder wealth What do we want these decision tools NPV as one example to measure We want to be able to separate the good projects from the bad projects o i e Accept Reject Decision We want to be able to rank the good projects so that we can see which projects are the best for our particular long term goals We want to be able to pick the best projects out of multiple mutually exclusive projects o Mutually exclusive only one can be picked out of a group of projects 2 FIN3403 LECTURE GUNTER Wednesday October 8th 2014 An important note projects have a life so you can think of a project s life like a timeline similar to how we viewed the life of bonds An important note There are two types of projects o Conventional projects there is an initial outflow in cash the initial investment and then a series of inflows over the life of the project o Unconventional projects there is an initial outflow in cash the initial investment and then a series of inflows and outflows in cash 1 NPV Continued In the event that a project is conventional NPV will calculate the present value of all the future cash flows o It is important that you don t forget to factor in the initial investment which is already in its present value form thus it doesn t need to be discounted from the NPV of all the future cash flows o NPV PV cash flows initial investment When calculating the NPV of a project you will be given a discount rate The discount rate AKA required return is the risk adjusted rate for a particular project of interest o Risk referring to the risk attributed to investing in a particular project o Thus you should not use the same discount rate for all projects Different projects will have different levels of risk associated with them NPV will turn out to be a negative number positive number or just 0 If NPV 0 the return on the project is fair o Don t confuse NPV 0 as the project not being profitable If NPV 0 positive value the return on the project is exorbitant o Unless the company investor that is investing in a project has a very special set of skills or unique circumstances such as being a monopoly that allows for an NPV greater than 0 you will rarely see a positive NPV value If someone is making an exorbitant return on an investment other people in the market will mimic these activities which creates competition If NPV 0 negative value you will not be receiving a return that is fair for the amount of risk involved with the project An important note You can think of the Accept Reject cutoff as being at 0 o Any project with an NPV below zero should be rejected o Any project with an NPV of zero or above should be accepted or considered 2 Average Accounting Rate of Return AAR average net income average book value AAR Issues with AAR o Does not take into account only cash but also noncash items such as deprecation expense o Does not take into account the time value of money FIN3403 LECTURE GUNTER Wednesday October 8th 2014 3 o Does not take into account risk Two Problems Leading to a Company Failing Liquidity problem mismatch in timing not enough cash or cash equivalents to pay off short term debts Solvency problem continuing to exist even when creating a constant loss in money 3 Payback Period The length of time it takes you to make back your initial investment When you take the cash flows of t 0 representing current time and subtract the cash flows of t 1 you will get some value o If that value is something other than zero then you must subtract the cash flows of t 2 o You follow this trend until you receive a value of zero which represents that your initial investment has been received from the cash flows of that investment over the time periods Issues with payback period o Ignores the time value of money o No adjustment for risk associated with the project Two projects may have similar cash flows but one may be more risky o Ignores all cash flows past the period in which your initial investment has be than the other earned back What if the cash flows following the payback period are negative To combat some of the issues with payback period someone created the discounted payback period Discounted Payback Period o Instead of just calculating the amount of periods it takes to regain the initial outflow in cash from the initial investment you would first discount all future cash flows to their
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