SMG FE 323 Study Guide - Midterm Guide: Net Present Value, Scenario Analysis, Cash Flow

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13 Jun 2018

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FE323 1

Financial Manager: 1. Make investment decisions (benefits and costs)

2. Make financing decisions (sell stock, raise debt)

3. Manage cash flow from operating activities (enough cash to operate)

Maximize wealth of stockholders = CREATE VALUE

NPV Decision Rule

NPV = PV (benefits) - PV (costs)

● Take the alternative with the highest NPV

● Reject negative NPV projects accepting them would reduce the value of the firm

NPV Profile

The Payback Rule

● The opportunity that pays back the initial investment the quickest is the best idea

● Accept if the period is less than required

● The calculation is simple but doesn’t discount future cash flows

The Internal Rate of Return

● Take any investment opportunity where IRR exceeds cost of capital

● Interest rate when NPV = 0, costs = benefits

● Scale doesn’t effect IRR but effects NPV

● Agree with NPV if costs come before benefits

Mutually Exclusive Projects

● Can’t just pick the project with a positive NPV, projects must be ranked and the best one

chosen, pick project with highest NPV, lower cost of capital that is less risky

Crossover Point

● Discount rate that makes the NPV of the two alternatives equal

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Incremental Earnings

Net Working Capital

FE323 5

NPV Break Even NPV = 0

Accounting Break Even EBIT = 0

Scenario Analysis

● Looks at the entire scenario

● Several variables are likely to be impacted/ change multiple variables simultaneously

● Ex: what change can you make to price and units sold to BE?

Sensitivity Analysis

● Look at how NPV etc change as assumptions change

● How much the assumption will impact if wrong sensitize several variables to see which

potential errors project is vulnerable to

● Ex: what new price can we sell at to BE?

Capital Budgeting

● Determine whether long term investment like new machinery is worth the funding

○ Option to delay, expand, abandon

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FE323 6

Ratio Analysis

● Tells us if our company is being well operated and is in good financial condition

Does the company have control over its expenses?

Long term assets are hard to change quickly

● You can’t sell your equipment without disrupting production

Short term assets are easier to liquidate or build up

● Need to manage NWC efficiently

Inventory Turnover

● How efficiently company turns inventory into sales

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Document Summary

Manage cash flow from operating activities (enough cash to operate) Take the alternative with the highest npv. Reject negative npv projects accepting them would reduce the value of the firm. The opportunity that pays back the initial investment the quickest is the best idea. Accept if the period is less than required. The calculation is simple but doesn"t discount future cash flows. Take any investment opportunity where irr exceeds cost of capital. Interest rate when npv = 0, costs = benefits. Scale doesn"t effect irr but effects npv. Agree with npv if costs come before benefits. Can"t just pick the project with a positive npv, projects must be ranked and the best one chosen, pick project with highest npv, lower cost of capital that is less risky. Discount rate that makes the npv of the two alternatives equal. Several variables are likely to be impacted/ change multiple variables simultaneously. Look at how npv etc change as assumptions change.

Related Questions

Question 1 Diana Dennison is a financial analyst working for a large chain of discount retail stores. Her company is looking at the possibility of replacing the existing fluorescent lights in all of its stores with LED lights. The main advantage of making this switch is that the LED lights are much more efficient and will cost less to operate. In addition, the LED lights last much longer and will have to be replaced after ten years, whereas the existing lights have to be replaced after five years. Of course, making this change will require a large investment to purchase new LED lights and to pay for the labor of switching out tens of thousands of bulbs. Dian plans to use a 10-year horizon to analyze this proposal, figuring that changes to lighting technology will eventually make this investment obsolete. Diana’s friend and coworker, David, has analyzed another energy-saving investment opportunity that involves replacing outdoor lighting with solar-powered fixtures in a few of company’s stores. David also used a 10-year horizon to conduct his analysis cash flow forecasts for each project appear below. The company uses a 10% discount rate to analyze capital budgeting proposals.

Year	LED project	Solar project
0	-RM4,200,000	-RM500,000
1	700,000	60,000
2	700,000	60,000
3	700,000	60,000
4	700,000	60,000
5	1,000,000	60,000
6	700,000	60,000
7	700,000	60,000
8	700,000	60,000
9	700,000	60,000
10	700,000	60,000

a) What is the Net Present Value (NPV) of each investment? Which investment (if either) should the company undertake? (5 marks)

b) David approaches Diana for a favor. David says that the solar lighting project is a ‘pet’ project of his boss, and David really wants to get the project approved to curry favor with his boss. He suggests to Diana that they roll their two projects into single proposal. The cash flows for this combined project would simply equal the sum of the two individual projects. Calculate the NPV of the combined projects. Does it appear to be worth doing? Would you recommend investing in the combined project? (4 marks)

c) Do the net present value (NPV) and internal rate of return (IRR) always agree with respect to accept-reject decisions; with respect to ranking decision? Explain. (3 marks)

ultramarinehorse204

The Dilemma at Day-Pro Comparison of Capital Budgeting Techniques The Day-Pro Chemical Company, established in 1995, has managed to earn a consistently high rate of return on its investments. The secret of its success has been the strategic and timely development, manufacturing, and marketing of innovative chemical products that have been used in various industries. Currently, the management of the company is considering the manufacture of a thermosetting resin as packaging material for electronic products. The Companyâs Research and Development teams have come up with two alternatives: an epoxy resin, which would have a lower startup cost, and a synthetic resin, which would cost more to produce initially but would have greater economies of scale. At the initial presentation, the project leaders of both teams presented their cash flow projections and provided sufficient documentation in support of their proposals. However, since the products are mutually exclusive, the firm can only fund one proposal. In order to resolve this dilemma, Tim Palmer, the Assistant Treasurer and a recent MBA from Drexel University, has been assigned the task of analyzing the costs and benefits of the two proposals and presenting his findings to the board of directors. Tim knows that this will be an uphill task, since the board members are not all on the same page when it comes to financial concepts. The Board has historically had a strong preference for using rates of return as its decision criteria. On occasions it has also used the payback period approach to decide between competing projects. However, Tim is convinced that the net present value (NPV) method is least flawed and when used correctly will always add the most value to a companyâs wealth. The appropriate discount rate for the projects is a required rate of return of capital of 10% (opportunity cost of capital). After obtaining the cash flow projections for each project (see Tables 1 & 2), and crunching out the numbers, Tim realizes that the hill is going to be steeper than he thought. The various capital budgeting techniques, when applied to the two series of cash flows, provide inconsistent results. The project with the higher NPV has a longer payback period as well as a lower Accounting Rate of Return (ARR) and Internal Rate of Return (IRR). Tim scratches his head, wondering how he can convince the Board that the IRR, ARR and Payback Period can often lead to incorrect decisions. Table 1. Synthetic Resin Cash Flows Synthetic Resin Year 0 1 2 3 4 5 Net Income $150,000 $200,000 $300,000 $450,000 $500,000 Depreciation $200,000 $200,000 $200,000 $200,000 $200,000 Net Cash Flow $(1,000,000) $350,000 $400,000 $500,000 $650,000 $700,000 Table 2. Epoxy Resin Cash Flows Epoxy Resin Year 0 1 2 3 4 5 Net Income $440,000 $240,000 $140,000 $ 40,000 $ 40,000 Depreciation $160,000 $160,000 $160,000 $160,000 $160,000 Net Cash Flow $(800,000) $600,000 $400,000 $300,000 $200,000 $200,000 Questions: In looking over the documentation prepared by the two project teams, it appears to you that the synthetic resin team has been somewhat more conservative in its revenue projections than the epoxy resin team. What impact might this have on the Payback Period, NPV, and IRR calculations for the synthetic resin project? How does this complicate comparing the synthetic resin and epoxy resin projects? Is being conservative in revenue projections a good practice? What adjustments might be made? Comment

Amongst corporations, sole proprietorships and partnerships, approximately what percentage of revenues are generated by corporations?

50%

42%

33%

82%

Question 2

What should be the financial goal of any firm?

attracting and acquiring capital and investing it

maximization of the ownersâ wealth

offering quality products at fair prices

quality customer service

Question 3
4 pts
Which of the following statement(s) is \ are true regarding the corporate management team?

In a corporation, ownership and direct control are typically separate.

Board of Directors is elected by shareholders and has ultimate decision-making authority

The Chief Executive Officer (CEO) â the Board typically delegates day-to-day decision making to the CEO.

All of the above

Question 4
4 pts
When calculating the present value of either a future single sum or a future annuity, it involves a process called discounting. The applicable interest rate to perform the discounting function is usually called the

yield to maturity

compound interest rate

discount rate

none of the above

Question 5
4 pts
_________________ are used to present additional information about items included in the financial statements and to present additional financial information.

stock certificates

Notes to financial statements

Preferred stocks

Convertible securities
Question 6
4 pts
What should be the financial goal of any firm?

maximization of the ownersâ wealth

attracting and acquiring capital and investing it

offering quality products at fair prices

quality customer service

Question 7
4 pts
A competitive market is one in which a _____ numbers of producers compete with each other to satisfy the wants and needs of a _____ number of consumers.

Large, small

Small, small

Large, large

Small, large

Question 8
4 pts
The Valuation Principle is an analysis between the value of the ______ of a financial alternative and the value of its ______.

revenues, income

benefits, costs

expenses, costs

Question 9
4 pts
The Net Present Value rule implies that we should compare a projectâs net present value (NPV) to___________. (zero \ future value \ the past).

Zero

Future Value

The Past

An Estimate

Question 10
4 pts
The internal rate of return (IRR) rule will _______ agree with the Net Present Value rule on a given investment project.

always

never

sometimes

none of the above

Question 11
5 pts
The law of one price exists due to arbitrage opportunities. If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will ______ the asset in the more expensive market and ________ it where prices are lower.

sell, purchase

purchase, sell

purchase, purchase

sell, sell

Question 12
5 pts
Approaching every problem using a timeline is a(n) ________ idea because timelines identify events in a transaction or investment which might otherwise be easily overlooked.

good

bad

indifferent

unrealistic

Question 13
5 pts
The present value (PV) of a stream of cash flows is the _______ the present values of each individual cash flow

difference between

product of

sum of

same as

Question 14
5 pts
As the number of periods increases, present value (increases\decreases\stays the same).

increases

decreases

stays the same

is unrelated

Question 15
5 pts
When a constant cash flow will occur at regular intervals for a finite number of periods of time, it is called a(n) __________.

annuity

perpetuity

interest payment

principle payment

Question 16
5 pts
When a constant cash flow will occur at regular intervals forever, it is called a(n) ___________.

annuity

perpetuity

interest payment

principle payment

Question 17
5 pts
The NPV measures the ______ change in shareholder wealth that arises from undertaking a project.

consistent

dollar

annual

semi-annual

Question 18
5 pts
When calculating the present value of either a future single sum or a future annuity, the applicable interest rate is usually called the _______ rate

compounding

inverted

market

discount

Question 19
5 pts
To endow a perpetuity is the same as calculating the present value (PV) of a perpetuity. Say you want to endow an annual graduation party at your alma mater. You want the event to be a memorable one, so you budget $30,000 per year forever for the party. If the university earns 8% per year on its investments, and if the first party is in one yearâs time, how much will you need to donate to endow the party?
The formula for PV of a perpetuity = C\r; = $30,000 \ 0.08; =

$3,750

$37,500

$375,000

$3,750,000

Question 20
5 pts
With an Ordinary Annuity, payments are required at the ________ of each period. An example of this is bonds which usually pay coupon payments at the end of every six months until the bond's maturity date.

beginning

middle

end

payments are not required

Question 21
5 pts
Sales of securities that the seller does not own is called a:

stop-loss order

short sale

limit order

maintenance margin

Question 22
5 pts
What is the name of the market where money market securities, bonds, and mortgages are originated and traded?

debt securities market

foreign exchange market

derivative securities market

equity securities market

Question 23
5 pts
If an investor feels the price of a stock will decline in the future, which trade should the investor undertake?

market order

buy on margin

limit order

short sale

Question 24
5 pts
For risk averse investors, how much return is expected for taking on more risk?

lower

equal

zero

higher

Question 25
5 pts
A ___________________ is a highly regulated document which details the issuers operations and finances and must be provided to each buyer of a newly issued security.

Prospectus

An underwriting agreement

A best efforts agreement

none of the above

Question 26
5 pts
Which of the following statements about liquidity ratios is true?

The lower the quick ratio relative to the current ratio, the safer a firm is in terms of liquidity.

The higher the current ratio, the more likely a firm is able to pay its short-term obligations.

The quick ratio is always between 0 and 1.

All the above statements are true.

Question 27
5 pts
The ability of a firm to meet its short-term debt obligations as they come due is indicated by which of the following ratios:

liquidity ratios

asset utilization ratios

financial leverage ratios

profitability ratios

Question 28
5 pts
Which one of the following financial statements reports a firmâs assets and the claims on assets?

balance sheet

income statement

statement of changes in financial position

cash flow statement

Question 29
5 pts
The extent to which assets are used to support sales is indicated by which of the following ratios:

liquidity ratios

asset utilization ratios

financial leverage ratios

profitability ratios

Question 30
5 pts
The extent to which assets are financed by borrowed funds and other liabilities is indicated by:

liquidity ratios

asset utilization ratios

financial leverage ratios

profitability ratios

Question 31
5 pts
The basic price that equates the demand for and supply of loanable funds in the financial markets is the __________:

interest rate

yield curve

term structure

cash price

none of the above

Question 32
5 pts
Federal obligations usually issued for maturities of two to ten years are called:

Treasury bonds

Treasury notes

Treasury bills

Agency issues

Question 33
5 pts
An increase in the demand for loan-able funds, holding supply constant, will cause interest rates to:

increase

decrease

stay the same

none of the above

Question 34
5 pts
As interest rates rise, the prices of existing bonds will:

rise

stay the same

fall

either a or b

Question 35
5 pts
In an inflationary period, interest rates have a tendency to:

rise

fall

stay the same

act erratically

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SMG FE 323 Study Guide - Midterm Guide: Net Present Value, Scenario Analysis, Cash Flow

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