SCM 305: Chapter 6
42 Cards in this Set
Front | Back |
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Capital budgeting
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what long-term investments should a firm take on?
1. does the decision rule adjust for the time value of money?
2. does the decision rule adjust for risk?
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"net"
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indicates we are subtracting something out
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NPV (net present value)
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gives the difference b/t the cash flows that the project generates & the cost of the project in today's dollars
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NPV rule
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to accept investments that have positive values and reject ones with negative values
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NPV & "r"
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-this is also known as the discount rate that is chosen for the analysis will reflect how risky the project is
- the higher this is the more risky the project is
- the higher this is the lower the NPV is
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Pros of NPV (1 of 3)
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takes into account TVM (time value of money)
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Pros of NPV (2 of 3)
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takes into account project risk
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Pros of NPV (3 of 3)
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ALWAYS leads you to the right decision
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Cons of NPV (1 of 3)
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cash flows difficult to estimate
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Cons of NPV (2 of 3)
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r can be difficult to estimate
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Cons of NPV (3 of 3)
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management may want to use IRR, as it is easier to understand
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IRR (Internal rate of return)
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- the most important alternative to NPV
- often used in conjunction w/ NPV
- has a percentage, it is more often intuitive to people
- does not always lead to the right decision
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IRR decision rule
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Accept the project is the ___ is greater than the required return
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Pros IRR (1 of 4)
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will often lead you to the same decision as NPV
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Pros IRR (2 of 4)
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takes into account TVM & accounts for project risk
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Pros IRR (3 of 4)
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"return" is intuitively appealing & a simple way to communicate the value of a project to non-financial managers
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Pros IRR (4 of 4)
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if it is high enough, you may not need to estimate a required return
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Cons IRR (1 of 2)
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project can get multiple of these; leading to an incorrect decision
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Cons IRR (2 of 2)
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if have mutually exclusive projects or unconventional cash flows, can lead to incorrect decisions
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Unconventional Cash Flows (IRR)
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-when the cash flows change signs more than once, there is more than one IRR
- when you have this, use the NPV to evaluate the project.
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Mutually Exclusive projects (IRR)
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- if you choose one, you can not choose the other
- i.e.: you can chose to make the product of buy the product, but not both.
- NPV: choose the project w/ higher NPV
- IRR: choose project w/ higher IRR
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ALL PROJECTS
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- looking to create the most value
- CASH IS KING!
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NPV
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directly measures the INCREASE IN VALUE to the firm & is the most reliable project evaluation tool
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higher & NPV
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As the discount rate increases (indicating a _______ risk level), the ___ decreases
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IRR
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the ___ is the r that makes the NPV = 0.
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unconventional cash flows or mutually exclusive projects
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the npv & irr will lead you to do the same decision except when you have ______________ _____________ _______________ & ________________ _______________ projects.
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NPV
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if the ___ is greater than 0, the IRR is higher than the discount rate used in the ___ calculation
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payback period
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how long does it take to get the initial cost back (break-even) in a nominal sense?
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Payback decision rule
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accept if the ________ period is less than some present limit
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Pros payback (1 of 2)
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easy to understand
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pros payback (2 of 2)
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adjusts for uncertainty of later cash flows
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Cons payback (1 of 3)
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ignores the time value of money & project risk
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Cons payback (2 of 3)
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requires an arbitrary cut off point & ignores cash flows beyond this cutoff date
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Cons payback (3 of 3)
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biased against long-term projects, such as research and development, & new projects
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profitability index
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the present value of an investment's future cash flows divided by its initial cost (positive amount)
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payback
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(the investment - how much had paid back as of __ year) / amount get the next year
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P.I.
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Pv of cash flows / initial cost
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p.i. decision rule
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accept and investment if it's ______ _______ is greater than 1
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pros pi (1 of 3)
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closely related to NPV (takes into account TVM & project risk), generally leading to the right decisions
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pros pi (2 of 3)
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easy to understand and communicate
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pros pi (3 of 3)
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may be useful when available investment funds are limited
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Cons pi (1 of 1)
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may lead to incorrect decisions in comparisons of mutually exclusive investments
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