FIN 357 Study Guide - Midterm Guide: Net Present Value, Payback Period, Cash Flow

218 views3 pages

reddinosaur956

4 Jan 2017

School

Department

Course

Professor

For unlimited access to Study Guides, a Grade+ subscription is required.

Document Summary

Focus on capital budgeting decision making process for accepting or rejecting projects. Npv accept a project if npv > 0, reject if npv < 0 npv rule. Accepting positive npv projects benefits the stockholders. The value of the firm rises by the npv of the project. Value additivity = sum of the values o the different projects, divisions, or other entities within the firm. Implies that contribution of any project to a firm"s value is simply the npv of the project. Opportunity cost = discount rate on a risky project that one can expect to earn on a financial asset of comparable risk. Payback period rule particular cutoff date is selected all projects that have payback periods before the cutoff date are accepted and all those that pay off after the cutoff date are rejected. Timing of cash flows within the payback period: does not consider timing of cash flows within payback period npv discounts the cash flows properly.

Related Questions

General Co. is considering investing $3,000,000 in a project that is expected to generate the following net cash flows:

Year 1 = $275,000

Year 2 = 400,000

Year 3 = 475,000

Year 4 = 475,000

General Co. uses WACC of 10% when evaluating proposed capital budgeting projects. Based on these cash flows, what is the project's profitability index (PI)?

General Co. decision to accept or reject the project is indepedent of its decision on other projects. Based on the project's PI, should the firm accept or reject?

By comparison, what is the NPV of this project? On the basis of evaluation criterion, should General Co. invest/not invest because the project will/will not increase the firm's value?

A project with a negative NPV will have PI that is equal to 1/greater than 1/less than 1 ; when it has a PI of 1.0, it will have a NPV greater than $0/less than $0/equal to $0 ?

Thank you!

ochregnat997

Capital budgeting involves choosing projects that add value to the firm. The net present value (NPV), internal rate of return (IRR) and payback period methods are the most common approaches to project selection. At its core, capital budgeting is measuring an accounting of costs versus benefits. In a way, all business decisions are a series of capital budgeting decisions. Get it wrong, and you can destroy a company.

The capital budgeting tools help financial managers decide on the desirability of the projects. In the real world, however, managers sometimes will make decisions that don't necessarily agree with the decision rules of the payback period, NPV or IRR methods.

For example, consider the two mutually exclusive projects below.

Investments	Cost	Cash Flow 1	Cash Flow 2
Project A	$ 50	$ -	$ 100
Project B	$ 50	$ 50	$ 25

According to the payback period, project B should be selected. Although both projects cost the same, project B has a payback period of one period, while project A will payback in roughly 1.5 periods.

Assuming the discount rate of 5%, NPV(A) = $41 and NPV(B) = $20.

This example illustrates the limitations of the payback period method. Even though the payback period method points to project B, the NPV method points to project A since it has more than twice the NPV value to that of project B. Yet the manager may choose project A. Why?

It may be that the project stakeholder is requesting a quicker return in cash.

For this discussion, create an example problem where two (or more) methods contradict each other. What would be the "appropriate" choice (which project would you choose)? In what cases would you not choose the "best" choice?

bluelizard621

Your first assignment in your new position as assistant financial analyst at Caledonia Products is to evaluate two new capital-budgeting proposals. Because this is your first assignment, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at assessing your understanding of the capital-budgeting process. This is a standard procedure for all new financial analysts at Caledonia, and it will serve to determine whether you are moved directly into the capital-budgeting analysis department or are provided with remedial training. The memorandum you received outlining your assignment follows:

To: The New Financial Analysts
From: Mr. V. Morrison, CEO, Caledonia Products
Re: Capital-Budgeting Analysis

Provide an evaluation of two proposed projects, both with 5-year expected lives and identical initial outlays of
$110,000. Both of these projects involve additions to Caledoniaâs highly successful Avalon product line, and as
a result, the required rate of return on both projects has been established at 12 percent. The expected free cash
flows from each project are as follows:

	Project A	Project B
Initial outlay	-$110,000	-$110,000
Inflow year 1	20,000	40,000
Inflow year 2	30,000	40,000
Inflow year 3	40,000	40,000
Inflow year 4	50,000	40,000
Inflow year 5	70,000	40,000

In evaluating these projects, please respond to the following questions. For questions from (a) to (j) assume that the projects are independent. That is both could be accepted if both are acceptable.
a. What is the payback period on each project? If Caledonia imposes a 3-year maximum acceptable payback period, which of these projects should be accepted?
b. What are the criticisms of the payback period?
c. Determine the NPV for each of these projects. Should they be accepted?
d. Describe the logic behind the NPV.
e. Determine the PI for each of these projects. Should they be accepted?
f. Would you expect the NPV and PI methods to give consistent accept/reject decisions? Why or why not?
g. Determine the IRR for each project. Should they be accepted?
h. What reinvestment rate assumptions are implicitly made by the NPV and IRR methods? Which one is better?
i. Determine the MIRR for each project. Should they be accepted?
j. Describe the logic behind the MIRR.
k. Rank the two project based on all above criteria and make a recommendation as to which (if either) should be
accepted under the assumption that the projects are mutually exclusive.

l. Caledonia is considering two additional mutually exclusive projects. The free cash flows associated with these projects are as follows:

	Project A	Project B
Initial outlay	-$100,000	-$100,000
Inflow year 1	32,000	0
Inflow year 2	32,000	0
Inflow year 3	32,000	0
Inflow year 4	32,000	0
Inflow year 5	32,000	200,000

The required rate of return on these projects is 11 percent.
1. What is each projectâs payback period?
2. What is each projectâs NPV?
3. What is each projectâs IRR?
4. What has caused the ranking conflict?
5. Which project should be accepted? Why?

I ONLY NEED TO DO PART l. (the last question) I need to answer questions 1-5

ochreworm751

FIN 357 Study Guide - Midterm Guide: Net Present Value, Payback Period, Cash Flow

Document Summary

Get access

Related Documents

FIN 357 Lecture Notes - Lecture 6: Payback Period, Cash Flow, Net Present Value

ACTSC372 Study Guide - Midterm Guide: Net Present Value, Capital Market, Opportunity Cost

FIN-3403 Lecture Notes - Lecture 9: Cash Flow, Net Present Value, Discount Window

Related Questions