D076-Study-Guide-Unit-6
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D076-Finance Skills for Managers
Unit 6: Financial Decision Making
Unit Introduction: 1.
In finance, the saying "cash is king" emphasizes the importance of cash inflows for creating investment opportunities and value in a company. Applying this concept to real estate, imagine you own property near a university and are considering building an apartment complex. To assess the viability of this venture, you'd need to estimate potential yearly earnings by renting out apartments.
Factors like average occupancy, maintenance costs, and furnishing expenses should be considered. You'd also weigh alternative investments and borrowing costs, as you'll likely
need a bank loan for construction. The bank assesses your plan and market interest rates to determine the loan's interest rate. Once you have estimates of cash flows and project costs, using time value of money techniques will guide you in making the best decisions for your investment. This unit will teach you tools to evaluate projects, considering cash flows and costs, helping you make informed investment decisions that add significant value.
Module 10: Investment Decisions
1. Lesson 37: Net Present Value
a.
What is Net Present Value (NPV)?
i.
Net present value (NPV) is a tool to assess if an investment adds value to
a company. It evaluates project profitability by calculating the difference
between the present value of future cash flows and the project's initial cost. If the NPV is greater than 0, it indicates that the present value of future cash flows exceeds the cost, making the project worthwhile. Understanding NPV involves summing present values of expected cash inflows and subtracting those of outflows, like the initial cost. NPV answers whether the project adds value to the firm in today's dollars. The decision rule is simple: accept the project if NPV is positive, as it contributes to shareholder wealth; reject it if negative, as it harms shareholder wealth.
b.
Advantages of NPV
i.
NPV (Net Present Value) has several advantages, and three key ones are
highlighted:
1.
Considers Time Value of Money:
a.
NPV recognizes the time value of money, acknowledging that a dollar today is worth more than a dollar in the future. It adjusts cash flows from different time periods to their present value, allowing comparisons at a common point in time.
2.
Calculates Value Added to the Firm:
a.
NPV provides a clear dollar amount representing the value added to the firm through the investment project. For instance, if the calculated NPV is $15,000, it means the project adds $15,000 to the firm's value at today's valuation.
3.
Considers Risk and Required Return:
a.
NPV incorporates risk by using the required rate of return or cost of capital as a discount rate. It recognizes that different investments and years may carry varying levels of
risk. Cash flows further in the future have less impact on NPV than those expected sooner, aligning with the principles of the time value of money.
c.
Disadvantages of NPV
i.
While NPV is a strong method for investment decisions, it comes with drawbacks:
1.
Requires Calculation of Appropriate Cost of Capital:
a.
One challenge is estimating the project's cost of capital. Factors like capital structures, cash flow timing, and investment variations affect risk levels and alter the required rate of return. If the estimate is too high, good projects might be skipped; if too low, bad investments might be made.
2.
Not Useful to Compare Projects of Varying Sizes:
a.
NPV isn't always effective for comparing projects of different sizes. For instance, comparing a $1.5 million project to a $1,500 project might show the larger project having a higher NPV and adding more profit. However, considering return percentage per investment amount, the smaller project could have a significantly higher rate of return. When facing a capital constraint, multiple smaller
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projects may generate higher overall profitability than one large project.
d.
Another Look at NPV
i.
Imagine you're a financial analyst assessing whether to build a nuclear power plant, using NPV (Net Present Value) as a tool. The project costs $5 million, and cash flows extend over 40 years. After extensive analysis, factoring in different scenarios, you find a positive NPV of $3.38. This means, with an 11% required rate of return, you'd earn a bit more than expected.
Now, the key is understanding that a positive NPV suggests you're earning more than your required rate. In this extreme example, you'd accept the project. However, relying solely on NPV has risks. What if estimates or scenarios are wrong? Unforeseen factors like material shortages or market changes could impact costs and demand.
This example highlights a common mistake in capital budgeting—thinking
NPV gives a strict rule. In reality, analyses guide decisions, but humans, not just numbers, make the final call. NPV is a tool, not a definitive answer.
e.
Lesson Summary
i.
NPV is the sum of expected discounted future cash flows of a project.
ii.
NPV tells you how much value would be added to a firm by doing a particular project.
iii.
Advantages of NPV are that it considers all cash flows, takes the time value of money into account, and considers the risk of the project.
iv.
Disadvantages of the NPV are that it may not always consider the whole picture when it is used to compare two different-sized or mutually exclusive projects and that it is difficult to estimate the cost of capital of a project.
f.
Skill Check
i.
What indicates to a firm that a project will increase shareholder wealth?
1.
The project’s cash flows are projected far into the future.
2.
The NPV is positive.
a.
Correct! The NPV is an estimate of the dollar amount that would be added to the firm’s value as a result of the investment.
3.
The project’s cash flows are projected closer to the present.
4.
The NPV is negative.
ii.
What part of the NPV calculation is very important but difficult to estimate?
1.
The cost of capital
a.
Correct! The cost of capital is affected by several things, such as different capital structures, timing of cash flows, and investment potential, which makes it difficult to calculate. An inaccurate prediction of the cost of capital may cause a firm to miss out on good projects or accept bad projects.
2.
The initial outlay
3.
The expected cash flows
4.
The life of the project
iii.
What is an advantage of using the NPV method?
1.
It can be used to compare multiple projects when a firm faces capital constraints.
2.
It does not consider the time value of money.
3.
It tells the percent return on an investment.
4.
It calculates the dollar value that would be added to the firm by doing the project.
a.
Correct! The NPV is expressed as a dollar amount, and the
result of the NPV calculation is exactly how much value would be added to the firm from that specific project.
iv.
What is a disadvantage of using the NPV method?
1.
It is not an effective way to compare projects with different time spans.
2.
It does not consider the time value of money.
3.
It is not an effective way to compare projects of different sizes.
a.
Correct! NPV should not be used to compare projects of different sizes.
4.
It often underestimates cash flows.
2. Internal Rate of Return
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a.
What Is Internal Rate of Return? i.
The Internal Rate of Return (IRR) is another method to evaluate investments, simpler than Net Present Value (NPV) but with limitations. Unlike NPV, which may be hard to interpret, IRR is straightforward. It's the
rate of return making NPV zero, indicating profitability. If IRR exceeds the discount rate, the project is profitable; if not, it's rejected.
However, IRR has downsides. Explaining NPV's value increase concept is tricky; IRR simply states the percentage return on investment. It involves trial and error without tools, but technology helps. Decision-wise, if IRR surpasses the cost of capital (hurdle rate), accept the project; if not,
reject.
For example, if a project's IRR is 15% with an 11% cost of capital, it's accepted. If IRR is below the cost, reject. If IRR equals the cost (both 11%), it's a neutral project—no added or lost value.
b.
Advantages of IRR
i.
The Internal Rate of Return (IRR) method has several advantages:
1.
Easy Interpretation: a.
IRR is easy to understand. If, for instance, the IRR is 12% on a project with an initial investment of $150,000, it means you'll earn a 12% return on your $150,000 investment.
2.
Considers Time Value of Money: a.
Like NPV, IRR acknowledges the time value of money. It calculates the rate where the sum of discounted future
cash flows equals the initial investment, accounting for the timing of each cash flow.
3.
No Required Rate of Return Needed: a.
Unlike NPV, IRR doesn't require estimating the required rate of return. This rate can be complex and subjective. IRR allows quick decisions without extensive calculations, making it easier to compare against an estimated cost of capital. If IRR exceeds the cost of capital, decisions become more straightforward.
c.
Disadvantages of IRR
i.
The Internal Rate of Return (IRR) method has several drawbacks:
1.
Not a Good Value Indicator: a.
IRR doesn't indicate the actual value created by a project, making it less reliable for capital-constrained firms seeking maximum value. Simply selecting projects with high IRRs may lead to suboptimal decisions.
2.
Ignores Mutually Exclusive Projects
a.
IRR cannot be directly compared between projects, making
it ineffective for choosing between mutually exclusive projects. This limitation may result in suboptimal project selection.
3.
Assumes Unrealistic Reinvestment
a.
IRR assumes reinvesting cash flows at the same rate, which may be unrealistic. This assumption might not reflect
the varying rates of return typical in real-world projects.
4.
Inability to Compare Different Durations
a.
IRR is unsuitable for comparing projects with different lifespans. It doesn't consider the timing of cash flows and reinvestment, leading to inaccurate comparisons.
5.
Requires Conventional Cash Flows
a.
IRR works well only with conventional cash flows (initial outlay followed by positive inflows). It struggles with unconventional cash flows, where changes in cash flow direction can result in multiple IRRs, making interpretation challenging. Due to these disadvantages, while IRR is widely used for its simplicity, using Net Present Value (NPV) is recommended for making decisions that
truly maximize firm value. Analysts often use multiple criteria to ensure comprehensive evaluations.
d.
Lesson Summary
i.
IRR is the return on the investment of a project as a percentage.
ii.
IRR makes the NPV of the project equal to zero.
iii.
The many advantages of the IRR include that it is easy to interpret, that it considers the time value of money and all cash flows, and that it does not first require the calculation of the cost of capital.
iv.
Disadvantages of the IRR include that the IRR does not consider the amount of value created, it cannot be used when comparing mutually exclusive projects or choosing multiple projects, it cannot be used when the cash flows of a project are not conventional, the reinvestment rate of
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the IRR is often unrealistic, and the IRR cannot be used to compare projects with different lives.
e.
Skill Check
i.
Suppose Alice is trying to explain to her friend, who knows nothing about the time value of money, why she should invest in Alice’s new company. Which method of valuation should Alice use to convince her friend to invest?
1.
Internal rate of return (IRR)
a.
Correct! The IRR is easy to interpret, which makes it ideal for communicating the potential of an investment decision.
2.
Cash budgeting
3.
Net present value (NPV)
4.
Debt-to-equity ratio
ii.
Which NPV value indicates that the IRR has been reached?
1.
$0.00
a.
Correct! The IRR is the rate of return that makes the NPV of a project equal to zero.
2.
-$100.00
3.
$15.00
4.
$99.99
iii.
Why is the IRR a poor valuation method for a project with unconventional cash flows?
1.
Projects with unconventional cash flows are only possible to evaluate using trial and error, which is not an acceptable way to calculate the IRR.
2.
The IRR method can be used only to calculate projects that add value to a firm, and projects with unconventional cash flows never add value to a firm.
3.
The hurdle rate is always too large for projects with unconventional cash flows.
4.
There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one.
a.
Correct! Projects with unconventional cash flows must be valued using NPV.
iv.
A company called Bobby’s Books is considering purchasing a new bookbinding machine. The company calculates the hurdle rate of the project to be 9% and the IRR to be 11%. Should the company purchase the bookbinding machine?
1.
Yes, because the IRR exceeds the cost of capital.
a.
Correct! When the IRR of a project is greater than the hurdle rate (the required rate of return, or cost of capital), it
indicates that the company should accept the project.
2.
Yes, because newer models of equipment are always profitable investments.
3.
No, because the old bookbinding machine still works.
4.
No, because the hurdle rate is lower than the IRR.
3.
Lesson 39: Profitability Index
a.
What Is Profitability Index?
i.
The Profitability Index (PI) is a method similar to NPV but is not presented
as a dollar value. Instead, it provides a ratio that helps interpret the return on investment. The PI is calculated by dividing the present value of future cash flows by the initial project cost. If the PI is greater than 1, it indicates that the project's present value of cash flows is higher than the project cost, making it a favorable investment.
The PI addresses a key issue with NPV, as it offers a percentage-based understanding of the return generated by an investment. For instance, if the analyst states an NPV of $10,000 for a project, the manager might not
gauge how significant the investment is. However, the PI, by comparing the payoff to the initial investment, provides a clearer perspective. A PI of 1 is the break-even point, with values above indicating a positive return and values below suggesting a shortfall.
a.
Decision Rule:
i.
Accept a project with a PI greater than 1.
ii.
Reject a project with a PI less than 1.
iii.
If the PI is exactly 1, be indifferent about the project, as it provides a return equal to the cost of capital.
This decision rule aligns with the NPV analysis, where projects are accepted if NPV is greater than zero, rejected if less than zero, and indifferent if exactly zero.
b.
Advantages of Pi
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i.
The Profitability Index (PI) method has several advantages, including those shared with the NPV method. It considers the time value of money, incorporates the risk of future cash flows through the cost of capital, includes all future cash flows, and indicates whether an investment will add value to the company. If the PI is greater than 1, it signifies that the project will contribute value to the company.
A unique advantage of the PI method is its usefulness for ranking and selecting projects when there's a limited capital available for investment. In a scenario with a capital constraint of $8,000, the PI method helps prioritize projects effectively. For example, in a comparison of four projects based on IRR, NPV, and PI, the ranking differs. The PI method, in this case, is valuable for decision-making, as it guides the firm to choose Projects 3, 4, and 1 within the budget constraint, maximizing the company's value at $465. This demonstrates the PI method's ability to optimize project selection under limited capital conditions.
c.
Disadvantages of PI
i.
The Profitability Index (PI) method has two main drawbacks. Firstly, it requires the calculation of the cost of capital, which can be challenging due to varying cash flow timings and potential differences in capital structures among projects. Inaccurate estimations of the cost of capital may result in unreliable information for decision-making.
Secondly, the PI method is not suitable for mutually exclusive projects. In situations where a firm can choose only one project from a set of mutually
exclusive options, the PI may not always guide the selection of the project
that adds the highest value to the firm. This limitation arises because
smaller projects tend to have higher PIs, but larger projects could contribute more significant value to the company.
d.
Lesson Summary
i.
The PI is the ratio of discounted benefits to discounted costs.
ii.
The biggest advantage of PI is that it is useful for ranking multiple projects
when the budget is limited.
iii.
The disadvantages of PI are that it requires an estimation of the cost of capital and cannot be used to compare mutually exclusive projects.
e.
Skill Check
i.
Which capital investment evaluation method is presented as a ratio?
ii.
Profitability index (PI)
1.
Correct! The PI is the ratio of discounted benefits to discounted costs.
iii.
Quick ratio
iv.
Net present value (NPV)
v.
Internal rate of return (IRR)
vi.
How does the PI aid in interpretation of the NPV?
1.
It converts the NPV to a percentage, which is easier for management to understand.
2.
It gives an idea of the return generated by a project.
a.
Correct! The PI scales different-sized projects so that their returns are comparable.
3.
It does not take into account the initial outlay of the project, which makes the NPV easier to understand in comparison.
4.
It communicates the value that would be lost to the company if it rejected the project.
vii.
Should a firm accept a project that has a PI of 0.8? Why?
1.
No, because the project would be generating cash inflows that are
20% short of the initial investment.
a.
Correct! As a rule, firms should accept only projects that have a PI greater than 1.
2.
No, because the PI is supposed to be represented as a dollar amount.
3.
Yes, because the PI is less than the cost of capital.
4.
Yes, because the PI would generate cash flows that are 80% more
than the initial investment.
viii.
You calculate the PI of a project to be 1 but realize that some aspect of your calculation was incorrect and needs to be adjusted. Which adjustment to the PI estimation should cause you to reject the project?
1.
The cash flows were underestimated, so the adjusted annual cash
flows are higher than the original ones.
2.
The cost of capital was underestimated, so you adjust the cost of capital to be higher.
a.
Correct! Increasing the cost of capital decreases the PI. Therefore, the new PI will be less than 1, and you should reject the project.
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3.
The length of project was underestimated, so in the new estimation, the life of the project is a couple of years longer with positive cash flows.
4.
The initial outlay estimation was inaccurate, and after you adjust it,
the new initial outlay is lower than the original.
4. Lesson 40: Financial Securities and Capital Investment
a.
Bonds
i.
Companies often raise debt financing through bond offerings, where they offer bond instruments to the public, receiving payments and promising future repayment. Bonds involve regular payments, known as coupons, and a future repayment. The bond specifies payment details, face value (repayment amount), and duration. Using time value of money concepts, future payments are discounted to determine the bond's present price, considering a required rate of return.
Historically, bonds had physical coupons for periodic payments, but now it's done electronically. Bonds are crucial for corporate debt capital, allowing firms to borrow directly from investors. Bonds represent a debt agreement, promising repayments and interest to bondholders. The bond market, larger than stocks, plays a significant role in the U.S. securities market.
Bonds are fixed-income securities, providing fixed interest payments. Key
parameters include par value (repayment sum), coupon rate (interest rate), and maturity. Yield to maturity (YTM) is the return if held till maturity.
Bond prices fluctuate based on market YTM. Covenants outline issuer
commitments, protecting bondholders. Bonds may be premium, par, or discount based on trading above, at, or below par value. Types include callable, convertible, debentures, fixed-rate, floating-rate, investment-
grade, junk, municipal, secured, and U.S. Treasury bonds, among others.
Investors consider goals, required return, risk tolerance, and diversity when deciding to invest in bonds or other securities.
b. Stocks
i.
Stocks represent ownership in a company, with ownership determined by the number of shares held. If a company has 100 shares and you own one, you have a 1% ownership. Two main types of stocks are preferred and common. Preferred stockholders receive annual dividends at a fixed rate, even if the company doesn't pay, without penalties. They usually lack voting rights. Common stockholders, however, can vote in company meetings, regardless of the number of shares owned. In case of liquidation, preferred shareholders are paid before common shareholders,
who have the lowest claim on company earnings.
Stockholders have a residual claim on company earnings and assets, proportionate to their ownership percentage. Unlike debt, stocks have no maturity, and ownership persists unless sold. Stocks are traded on exchanges like NYSE, NASDAQ, etc., with prices influenced by supply and demand. Major indices, like S&P 500, track stock performance.
Companies issue stock through Initial Public Offerings (IPOs), setting the price. Subsequent trading happens on the secondary market. Stock advantages include no fixed interest payments, allowing funds for
company growth. Types of stock include common and preferred, each with distinct characteristics, valuation methods, and pros and cons.
Common stockholders own equity, usually with voting rights. They have the lowest claim on earnings and assets, earning returns after other obligations are met. Common stock has unlimited earnings potential and persists as long as the company exists. Preferred stock is a hybrid security, resembling equity and debt. It pays fixed dividends, lacks voting rights, but can accumulate unpaid dividends without penalties. Preferred stockholders are prioritized in liquidation. Comparison between common and preferred stock is summarized in a table.
Stock valuation involves assessing market efficiency, calculating the stock's intrinsic value, and comparing it with the market price to identify undervalued or overvalued stocks.
c.
Capital Investment
i.
To increase wealth, firms consider capital investments, like building a new
factory. The investment's value is assessed by examining future cash flows, discounting them to the present using the time value of money. If the net present value is positive, the project adds value and contributes to
wealth creation. Capital investment is money put into a business for long-
term assets. Financial managers secure funds from individuals, venture capital firms, or financial institutions, often through loans, stocks, or bonds.
Companies make these investments for long-term growth, aiming to develop new products, enhance capacity, adopt cost-cutting technology, replace aging assets, and expand market share. Despite potential short-
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term downsides to earnings and growth, capital investments are crucial for a company's future success.
For example, Mazda, a Japanese car manufacturer, invested in a new factory in Mexico in 2014 to boost production capacity for Mazda2 and Mazda3 models. This decision, though costly, enabled Mazda to meet market demand more affordably than cars produced in Japan or the United States. In 2019, facing potential tariffs on imports, Mazda and Toyota decided to build a new American plant to avoid increased costs on
cars manufactured in Mexico. These strategic capital investment decisions contribute to long-term success and competitiveness.
d.
Lesson Summary
i.
Bonds are issued by companies to raise debt capital. Bonds pay coupons
and mature after a certain amount of time.
ii.
Stocks are issued by companies to raise equity capital and do not expire. They pay dividends and give owners certain ownership rights in a company, such as the right to residual claims.
iii.
Common stock represents equity in a company, has variable dividends, and confers voting rights on shareholders.
iv.
Preferred stock is a hybrid security that has fixed payments and does not confer voting rights on shareholders.
v.
Capital investment is a sum of money that a firm raises to invest in long-
term projects to achieve its objective of maximizing shareholder wealth.
e.
Skill Check
i.
Why might a firm prefer to raise capital through stocks instead of bonds?
1.
Stocks do not allow investors to have voting rights.
2.
Stocks do not require a firm to give up any ownership.
3.
Stocks do not require the firm to repay the par value to investors.
a.
Correct! Stocks are shares of ownership in a firm, so the value of the stock is not required to be returned to investors.
4.
Stocks provide a steady stream of income to a firm.
ii.
An investor just purchased a bond for $973 that has a par value of $1,000. What type of bond is this?
1.
A premium bond
2.
A discount bond
a.
Correct! When the market price is less than the par price of
a bond, you know that the YTM is currently higher than the coupon rate of that particular bond, so it is being sold at a discount.
3.
A par bond
4.
A preferred bond
iii.
In what way is preferred stock different from bonds?
1.
Companies must pay preferred stockholders but not bondholders before common stockholders.
2.
Companies are allowed to skip payments to preferred stockholders but not to bondholders.
a.
Correct! If companies skipped bond payments, they would go into default. Companies can skip payments for preferred stock. However, by skipping these payments, companies are not able to pay common stockholders and must pay dividends in arrears at some point.
3.
Preferred stock payments are fixed, but bond payments are not.
4.
Preferred stockholders do not have voting rights, but bondholders do.
iv.
Why might a firm seek capital investment?
1.
To pay short-term loans
2.
To fulfill expected dividend payments
3.
To purchase long-term assets for future growth
a.
Correct! Firms need funding for projects that will increase shareholder wealth in the future.
4.
To pay off bondholders
5. Lesson 41: Financial Security Valuation and Capital Investment Evaluation a.
Intrinsic Value
i.
Intrinsic value is the worth of an investment, company, product, or currency determined by fundamental analysis, not its market value. It's calculated by adding up discounted future cash flows generated by the asset, representing the present value of these future cash flows.
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Comparing intrinsic value to market value helps assess if the asset is overvalued or undervalued.
For instance, if you calculate the intrinsic value of a preferred stock in Company XYZ based on future dividends, required return, and risk to be $25 per share, and the market price is $20, the stock is considered undervalued and a good buy.
Calculating intrinsic value involves estimating the discount rate (considering inflation, risk, and opportunity cost) and projecting cash flows
based on growth rate or market share assumptions. The result is somewhat subjective, emphasizing that it's an estimate to aid decision-
making. When analyzing investments or businesses, both quantitative factors (like intrinsic value) and qualitative aspects (e.g., management history, competitive advantages) should be considered.
b.
Bond Valuation
i.
Bonds typically pay equal coupon payments every six months until maturity, and investors receive the final interest payment plus the bond's face value at maturity. Coupon payments are like an annuity, while the principal repayment is a lump sum. Let's explore an example:
Suppose you have a $1,000 bond with a 6% coupon rate, paying interest semiannually and maturing in three years. The bond's YTM is 7%, and its market price is $973.36. If you buy the bond today for $973.36, you'll receive semiannual coupon payments of $30 for three years, and at the end of Year 3, you'll get the $1,000 par value. Using time value of money functions, you can discount these future cash flows, finding that the
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bond's value today is -$973.36. This implies a 7% return if held until maturity.
Understanding the difference between the coupon rate and YTM is crucial. The coupon rate is fixed, determining future coupon payments. In contrast, YTM is the market's required return and can change based on market conditions and the company's fortunes.
In another example, if XYZ Co.'s bonds, with a 5% coupon rate, are selling for $1,023.45, paying interest semiannually, and maturing in four years, you can use time value of money calculations to find the annualized yield to maturity (YTM). Solving for the rate reveals a YTM of 4.35%. If your required rate of return is at least 5%, the bond's 4.35% YTM may not meet your criteria for investment.
c.
Stock Valuation
i.
Preferred Stock Valuation:
1.
To value preferred stock, we use a simple perpetuity model that assumes fixed dividends will continue indefinitely. The value of preferred stock is calculated by dividing the fixed annual dividend by the required rate of return. For instance, if a stock has a $3 dividend and a 10% required rate of return, the calculated value would be $30. Preferred stock valuation is straightforward as it involves fixed payments each year.
2.
Example: Preferred Stock Valuation
a.
Consider a preferred stock with a fixed annual dividend of $3.25. Assuming the company will exist indefinitely, the value is calculated using the perpetuity model:
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i.
v(ps)=D/k(ps)=$3.25/0.08=$40.63
If the market price is $43, the stock is considered overvalued, and if it's $38, it's undervalued.
ii.
Common Stock Valuation:
1.
Valuing common stock is complex, involving estimating cash flows
over an extended period. The Gordon Growth Model simplifies this
process by assuming dividends are paid every year and grow at a constant rate forever. The formula for common stock valuation is a.
V(cs)=D(1)/k(cs)−g where D(1) is the next year's dividend, k(cs) is the required rate of return, and g is the constant growth rate.
2.
Example: Common Stock Valuation
a.
Suppose a common stock pays a $1.05 dividend next year,
with a 3% growth rate and an 8% required rate of return. The calculated value using the Gordon Growth Model is $21.00. If the stock is trading at $20.53, it's undervalued, while at $24.75, it's overvalued. The return required on a stock can be determined using the Capital Asset Pricing Model (CAPM), considering the associated risk.
d.
Capital Asset Pricing Model
i.
Firm-specific risk, which can be diversified away, doesn't earn rewards for
investors. In the risk/return relationship, market or systematic risk is crucial. Beta measures the amount of market risk in an asset, indicating how its price varies with the market. A beta of 1 means the asset has the same risk as the market, while higher beta indicates more volatility
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(aggressive assets) and lower beta suggests less movement (defensive assets). The capital asset pricing model (CAPM) relates risk and return, helping determine the required rate of return on an investment. It is expressed as: R(i)=R(f)+β(i)(Rm−Rf)
1.
where R(i) is the return on the security, R(f) is the risk-free rate, R(m) is the market return, β(i) is the security’s beta, and R(m)
−R(f)is the market risk premium.
For example, if considering a stock with a beta of 1.6, a risk-free rate of 2.5%, and an expected market return of 7.5%, the required rate of return is calculated as:R(i)=2.5
If the expected return on the stock is 12%, it's undervalued. If it's 8%, it's overvalued. This helps investors make informed decisions based on risk and return.
e.
Capital Budgeting: Capital Investment Decision-Making
i.
Capital budgeting is the process of evaluating and planning for long-term asset purchases to increase firm value. These decisions are crucial, shaping the firm's future for decades. Entrepreneurs use capital budgeting to communicate and analyze investment ideas. NPV, IRR, and PI are criteria used in decision-making. For instance, if NPV is positive, accept the project; if PI is greater than 1, accept it. IRR compares the return to the cost of capital; if higher, accept. Examples illustrate how to apply these criteria. Considerations like cash flows and discount rates are
crucial due to their uncertainty.
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f.
Lesson Summary
i.
Time value of money functions are used to calculate the current value, or price, of a bond and a bond’s yield to maturity.
ii.
The perpetuity model is used to value preferred stock.
iii.
The Gordon growth model, derived from the dividend discount model, is used to find the intrinsic value of common stock.
iv.
The capital asset pricing model is used to determine the required return for stock.
v.
NPV, IRR, and PI can be used to evaluate whether capital investment is worth pursuing based on certain criteria.
g.
Skill Check
i.
Which method should you use to calculate a bond value?
1.
The perpetuity model
2.
The IRR method
3.
The constant growth model
4.
The PV function in Excel
a.
Correct! You should use the PV function in Excel given the rate, FV, nper, and rate input variables.
ii.
You are evaluating a common stock. What is a key assumption for this evaluation?
1.
Dividends are fixed.
2.
Coupon payments are made semiannually.
3.
The growth rate is assumed to stay the same forever.
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a.
Correct! Common stock valuation uses the constant growth
model under the assumption that the growth rate is constant forever.
4.
There is a maturity date.
iii.
What is the name for the process of evaluating and planning for purchases of long-term assets?
1.
The time value of money
2.
The constant growth model
3.
The perpetuity model
4.
Capital budgeting
a.
Correct! Capital budgeting is the process of evaluating and
planning for purchases of long-term assets.
6.
Module Summary
a.
The NPV method gives you an idea of the dollar value that would be added by doing a project; however, estimation of the cost of capital is difficult and can lead to incorrect valuation of the NPV.
b.
The IRR is easy to interpret, but it cannot be used if there are multiple sign changes in cash flows or if projects are mutually exclusive.
c.
The PI is useful when you have to rank projects due to capital constraints, but it cannot be used for mutually exclusive projects. Like the NPV, the estimation of cost of capital is difficult and may lead to incorrect valuation.
d.
Bonds are known as fixed-income securities because of their cash flow pattern, in which the borrower pays a fixed interest payment to the bondholders each year.
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e.
Common stock represents equity in a company, has variable dividends, and confers voting rights on shareholders. Preferred stock is a hybrid equity that has fixed payments and does not confer voting rights on shareholders and whose dividends must be paid before common stock.
f.
Time value of money techniques can be used to find the YTM and price of a bond.
g.
The perpetuity model is used to value preferred stock and the Gordon growth model is used to find the intrinsic value of common stock.
h.
The capital asset pricing model (CAPM) is used to determine the risk-return relationship for an asset and is a way to price risk.
7.
Module Quiz
a.
Why is it important to have an accurate, carefully calculated required rate of return as part of the NPV?
i.
An inaccurate required rate estimate could cause a firm to reject good projects or accept bad projects.
1.
Correct! While the required rate of return is the most difficult part of the NPV calculation to estimate, it is also the most important.
ii.
Lenders will provide a firm with funds to invest in a project only if the required rate of return is extremely accurate.
iii.
The SEC and GAAP require an accurate rate of return as part of their capital investment standards.
iv.
An accurate required rate of return actually is not very important, as the required rate of return is only a minor part of the NPV calculation.
b.
A company is trying to decide which of four projects to invest in.
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Project 1 has an IRR of 14% and an NPV of $54,000.
Project 2 has an IRR of 11% and an NPV of $67,000.
Project 3 has an IRR of 9% and an NPV of $60,000.
Project 4 has an IRR of 13% and an NPV of $47,000.
If the company can do only one project, which project should it choose to add the
greatest value to the firm?
i.
Project 4
ii.
Project 1
iii.
Project 3
iv.
Project 2
1.
Correct! The project with the highest NPV will bring the most value
to the company.
c.
The company Betsy’s Wigs is considering three potential projects that are not mutually exclusive. The IRR, NPV, and PI for each project are listed in the table below. Use this information to rank the projects in the order in which Betsy’s Wigs
should accept them to bring the most value to the firm.
Project IRR
NPV
PI
Project 1
23%
$820
1.02
Project 2
18%
$880
1.27
Project 3
21%
$790
1.35
i.
Project 2, Project 3, Project 1
ii.
Project 3, Project 2, Project 1
1.
Correct! The projects with the highest PIs should be accepted first.
iii.
Project 2, Project 1, Project 3
iv.
Project 1, Project 3, Project 2
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d.
The YTM of a bond went from 8% to 7%. What can be predicted about the price of the bond?
i.
It will increase.
1.
Correct! There is an inverse relationship between YTM and the price of a bond.
ii.
It will decrease.
iii.
It will stay the same.
iv.
It is not possible to predict what will happen to the bond price.
e.
A potential project to expand the size of an apartment complex will cost $100,000. Its calculated net present value is $5,000. Given this information, which statement is correct?
i.
The project should be rejected because it has a negative NPV.
ii.
The project should be rejected because it has a negative IRR.
iii.
The project should be accepted because it has a positive IRR.
iv.
The project should be accepted because it has a positive NPV.
1.
Correct! Because the NPV is positive, the project should be accepted.
Module 11: Capital Investment Decisions
1. Lesson 42: Important Attributes of Capital Budgeting
a.
Criteria to Consider for Capital Investment
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i.
An effective capital investment evaluation method has three crucial aspects:
1.
Considers all relevant cash flows during the project's lifespan.
2.
Takes into account the time value of money, recognizing that a dollar today is more valuable than a dollar in the future.
3.
Incorporates the cost of capital, reflecting the required rate of return on the project.
ii.
In evaluating capital budgeting, three ideal criteria stand out. First, it's essential to consider all relevant cash flows for determining project profitability. Second, the timing of these cash flows is crucial, recognizing that the time value of money influences project profitability. Third, being aware of project-specific risks, with the cost of capital playing a role in addressing these risks, is vital as well.
Let's delve into these criteria further. 1.
Firstly, an effective evaluation method must encompass all cash flows throughout the project's life. Capital projects, whether involving new machinery or product lines, typically span a considerable timeframe. Evaluating the enhancement of firm value
necessitates considering all future cash flows.
2.
Secondly, the timing of these cash flows matters. A project with a substantial future return may not be worth investing in today if that
return is received many years later. An ideal method adjusts cash flows to today's value, considering the time value of money.
3.
Thirdly, the method should accommodate varying risk levels between projects. Projects differ in risk, such as ExxonMobil's exploration and transportation ventures. Risk and return are
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correlated, so projects with higher risk demand a higher required return. It's crucial to consider these differences in risk and required
return when evaluating capital projects.
b.
Which Tool to Use?
i.
In the previous module, you learned about NPV, IRR, and PI methods for project evaluation. All three consider project cash flows and their timing. NPV and PI use the required rate of return to assess risk, while IRR compares the required rate of return to determine if the investment is worthwhile.
These methods are also applicable for evaluating capital investments. Typically, firms use multiple methods for different projects. For a single project, NPV is a good starting point as it provides the precise value added to the company. IRR indicates how far the estimated rate of return is from the cost of capital, showing room for misestimation. Note that there are cases where IRR cannot be used, like when cash flows are negative in any period.
c.
Capital Investment Example: Chocolate Factory
i.
A chocolate company considers three projects to automate candy bar wrapping and reduce costs. Project A adds a conveyer belt, Project B introduces an automated wrapping machine, and Project C combines wrapping and boxing. The company evaluates projects using NPV and IRR.
Project A (Conveyor Belt): Initial Cost $20,000, NPV $18,500, IRR 8%
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Project B (Automated Wrapping Machine): Initial Cost $50,000, NPV $36,000, IRR 17%
Project C (Wrapping and Boxing Machine): Initial Cost $100,000, NPV $12,200, IRR 27%
When comparing projects, NPV is the primary method, considering the highest NPV for maximum owner wealth. Project B is the best choice for the chocolate factory, with an NPV of $36,000, despite its lower IRR compared to Project C. NPV clearly indicates the overall value added to the firm, guiding the decision.
d.
Capital Investment Example: Project Ranking
i.
When a company faces capital constraints and has non-mutually exclusive projects, it needs a strategy to decide where to invest. Consider
a scenario with four projects and a capital constraint of $8,000:
Project 1: Initial Outlay $2,500, IRR 28%, NPV $125, PI 1.050
Project 2: Initial Outlay $3,500, IRR 21%, NPV $200, PI 1.057
Project 3: Initial Outlay $1,500, IRR 19%, NPV $100, PI 1.067
Project 4: Initial Outlay $4,000, IRR 17%, NPV $240, PI 1.060
Ranking based on criteria:
IRR: Project 1, Project 2, Project 3, Project 4
NPV: Project 4, Project 2, Project 1, Project 3
PI: Project 3, Project 4, Project 2, Project 1
Using the PI to scale NPV in terms of initial outlay, the company prioritizes
Project 3 and then Project 4, totaling $5,500 within the $8,000 constraint. If more capital is available, Project 2 would be next, followed by Project 1
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or saved for other projects. This strategy adds a total value of $465 to the firm.
Ignoring PI and relying only on NPV, the company would have chosen Projects 4 and 2, reaching the constraint at $7,500, resulting in a lower total value of $440.
If the decision were based on IRR, the company would select Projects 1, 2, and 3, using the full $8,000 and generating a total NPV of only $425.
In summary, using PI to rank projects and choosing the highest-ranked ones within the capital constraint adds the most value to shareholder wealth.
e.
Lesson Summary i.
An ideal evaluation method for capital investment considers three things: all the cash flows in the project, the timing of cash flows, and the cost of capital or risk of the project.
ii.
In most cases, you should use NPV as the primary method and use the other methods to supplement when making capital investment decisions.
iii.
If there are capital constraints when choosing multiple projects, use the PI
to rank the projects and then decide which projects to do based on the PI ranking.
f.
Skill Check
i.
Why is it important to consider all relevant cash flows in an ideal evaluation method for capital investment?
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1.
The value of a cash flow today is different from the values of a cash flow of the same dollar amount in 10 years.
2.
If you can receive money earlier, you can reinvest the cash into different projects earlier.
3.
Without considering every cash flow of a potential project, you do not know how the project will enhance the value of a firm.
a.
Correct! You need to include all the cash flows coming from a potential project to understand how much value they will add to the firm.
4.
A project’s cash flows may be uncertain.
ii.
Talia is comparing four mutually exclusive projects. In order to choose the
best project to optimize the goal of the firm, which capital budgeting method should Talia use?
1.
Time value of money
2.
Net present value (NPV)
a.
Correct! When you compare mutually exclusive projects, you should look at how much value is added by each project, because you can do only one of them. Therefore, you should use the NPV method to choose a project.
3.
Profitability index (PI)
4.
Internal rate of return (IRR)
iii.
Alphabet Co. has $50,000 to spend on capital investment projects for the next year. It will do as many projects as it has cash for. Alphabet Co. calculates the potential incremental cash flows and costs of the projects
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as well as the NPV, IRR, and PI for each project. How should the company decide which projects to invest in if it wants to maximize the total amount of value created?
1.
It should choose the projects with the highest PIs until all capital has been used.
a.
Correct! By choosing the projects with the highest PI, Alphabet Co. will be able to use its limited capital effectively to create the most overall value for the firm.
2.
It should choose the projects with the highest costs until all capital has been used.
3.
It should choose the projects with the highest NPVs until all capital
has been used.
4.
It should choose the projects with the highest IRRs until all capital has been used.
2. Lesson 43: Time Value of Money and Capital Investment
a.
Lesson Introduction
i.
Ever watched a home renovation show where they buy a rundown house,
fix it up, and sell it for a profit? These projects tie up cash until the sale, limiting other investment opportunities. Despite a quick turnaround, the profit may not outweigh the risks. With cash locked in, the time value of money decreases its purchasing power over years. This lesson highlights why it's crucial to factor in the time value of money when evaluating capital investments.
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b.
Time Value of Money in Capital Budgeting
i.
The time value of money is crucial in evaluating capital projects. It helps us determine the actual worth of a project to our company today and compare projects effectively. When forecasting financial values for a capital investment, discounting them at an appropriate rate brings them back to today's worth. This allows a common size comparison of projects and helps decide if the investment is worthwhile. The timing of cash receipts is vital due to inflation, opportunity cost, and risk. For instance, receiving returns earlier can increase purchasing power, reduce opportunity cost, and lower risk. This concept guides investment decisions by comparing the value of projects today based on their present
worth and costs. If benefits exceed costs, the project adds value; otherwise, alternative investment opportunities may be explored. Understanding the time value of money is crucial for informed decisions in
capital budgeting.
c.
Impact of TVM on Capital Budgeting Decisions: Amazon’s Project Drone
i.
In 2013, Jeff Bezos announced Amazon's plan to use drones for package delivery within five years. Before this, Amazon likely conducted a financial
analysis using capital budgeting methods like IRR, NPV, and PI. They considered cash outflows (drone investment, technology, space) and expected inflows (sales, cost savings). NPV required determining an appropriate cost of capital by assessing project risks and opportunity costs. Despite facing delays due to regulation and technical challenges,
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Amazon persisted, announcing an improved drone version in 2019. Regular capital budgeting and time value of money analysis helped them see the project's ongoing value, showcasing the importance of these financial tools.
d.
Lesson Summary
i.
What is opportunity cost as it relates to the time value of money?
1.
It is the lowered cost over time of money used for an investment.
2.
It is the opportunity you forgo to invest in other options due to the time scope of an investment.
a.
Correct! Opportunity cost is the cost that you have to give up for something as a result of investing in something else.
3.
It is the cost of having more investment options than one.
4.
It is the cost at the terminal stage of a project in a TVM model.
ii.
Why is the timing of cash flows an important characteristic of capital investment?
1.
Timing of cash flows is related to the sunk costs associated with those cash flows.
2.
Timing of cash flows is related to the opportunity cost associated with those cash flows.
a.
Correct! The cash flows of an investment need to be compared to the cash flows of other projects.
3.
Companies are wary of inflation risks due to timing of cash flows.
4.
Companies need to know if they will have enough cash inflows to pay off their debt expenses.
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iii.
You are considering four projects. The initial cost to start each project is $500,000, and the total cash inflows generated by each project are $600,000. Each project also has the same level of risk. The only difference between these four projects is the cash flow patterns.
Year 1
Year 2
Year 3
Project A
$200,000
$200,000
$200,000
Project B
$300,000
$200,000
$100,000
Project C
$100,000
$200,000
$300,000
Project D
$600,000
$300,000
-$300,000
Given the information above, which statement is correct about these four projects?
1.
All projects should yield the same amount of value for the firm.
2.
Project C should be chosen first given that this project takes the longest time to receive cash summing to $600,000.
3.
Project D should be chosen first given that the project will receive cash to sum to $600,000 the most quickly.
a.
Correct! Project D receives cash flows the most quickly of the four projects. Given the concept of the time value of money, Project D should generate the highest NPV.
4.
Project A should be chosen first given that the estimated cash flows are steady..
3. Lesson 44: Cost of Capital and Capital Investment
a.
Cost of Capital
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i.
The cost of capital is crucial in capital budgeting. Suppose a firm has a $50 million investment opportunity, and the cost of capital is the rate used to discount future cash flows. It represents the compensation investors expect for the risk they take in financing a business. Financing decisions involve determining the mix of debt and equity to fund assets. Bonds and stocks have different risks affecting their returns, and debt financing offers
tax shields. Projects also carry varying risks; for instance, opening a Costco in Arkansas is riskier than in Utah due to competition. Investors view returns as compensation, while managers see them as the cost of capital against which project returns are compared.
b.
Lesson Summary
i.
The investors in a firm have different required rates of return based on what type of security they invest in: bonds, preferred stocks, or common stocks.
ii.
The required rate of return for the investors is the cost of capital to the firm, or the cost of raising cash for capital investment.
iii.
Even if projects are seemingly the same, each project has different inherent risks that change the cost of capital to the firm.
iv.
Capital raised by debt, such as mortgages and bonds, have tax shields, but they do not produce an optimal capital structure for the firm.
c.
Skill Check
i.
Why is there always a cost for bringing funds into a business?
1.
Investors need an investment vehicle to fight inflation.
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2.
A business must compensate investors for the risk that they are taking to invest in the business.
a.
Correct! Investors need a reason to part with their money.
3.
A business must compensate investors for the opportunity cost of investing in the business.
4.
Investors will only choose the investment vehicle with the highest return.
ii.
What is the relationship between the risk and the rate of return?
1.
Investors must be incentivized with higher returns or else they will choose a risk-free asset.
2.
Risk has no relationship to the rate of return but is related instead to the cost of capital.
3.
The rate of return describes the inherent risk of a project.
4.
The higher the risk investors have to take on, the higher return they require.
a.
Correct! Investors will take on more risk if there is potential for a higher return.
iii.
How can having more debt benefit a company?
1.
It protects a company from having to buy more assets.
2.
Debt is never beneficial for a company due to its increasing costs over time.
3.
It allows management to retain more control over the company.
4.
Interest expense on debts is paid before taxes are calculated.
a.
Correct! This describes the tax shield advantage of debt.
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iv.
Which example demonstrates a financing decision in a firm?
1.
Whether a company should use a third-party public affairs firm to promote its new product
2.
How a company will increase its sales for next year by attracting new customers
3.
How a company will fund its assets and operations—namely, what
proportions of debt and equity the business will use
a.
Correct! This correctly characterizes a finance decision.
4.
Whether a company should hire executive leadership from outside
the company or promote managers from within
4. Lesson 45: Cash Flow Estimation in Capital Investment
a.
Incremental Cash Flows
i.
In capital budgeting, it's crucial to consider relevant cash flows for evaluating a project's impact on the overall value of the firm. This includes
incremental cash flows influenced by the project, both positive and negative. Incidental cash flows, like cannibalization costs, should also be considered. Sunk costs, incurred in the past and irretrievable, are irrelevant for analysis. Opportunity costs, representing the loss of using assets elsewhere, matter in capital budgeting. The focus is on incremental cash flows, excluding sunk costs and incorporating incidental and opportunity costs to assess a project's true value for the company.
b.
Lesson Summary
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i.
Incremental cash flows should be included when estimating cash flows of a project.
ii.
Incidental cash flows are a type of incremental cash flow that are indirectly created by a project but are not explicit revenues or costs.
iii.
Opportunity cost should also be accounted for in capital budgeting for a capital investment because a company loses its ability to use the same assets somewhere else.
iv.
Sunk costs are the costs that have already been incurred and are irrelevant to the project evaluation.
c.
Skill Check
i.
What are incremental cash flows?
1.
The sum of all positive and negative cash flows that create an incremental increase or decrease in revenue
2.
Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project
a.
Correct! This is the correct definition of incremental cash flows.
3.
All cash flows that the firm has that may be affected by accepting a new project
4.
The positive cash flows of a project discounted back to their present value
ii.
How does allocated overhead affect the selection of capital investment projects?
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1.
These cash flows are not a direct result of a specific project but are a general cost to the firm.
a.
Correct! These cash flows are irrelevant to your analysis.
2.
Accountants are paid to allocate cash flows such as “overhead” to the various projects of a firm. Therefore, these cash flows are added to new projects during analysis.
3.
Overhead is allocated to the various projects of the firm, but never
capital investment projects.
4.
Overhead represents costs from specific projects, so it tells us the overall impact of a project on a company.
iii.
How are non-incremental cash flows different from incidental cash flows?
1.
All incidental cash flows should be excluded. If a company will incur a cost regardless of whether it adopts a specific project, the cost should not be counted as a cost of the project.
2.
All non-incremental cash flows should be included. It is unclear if a
company will incur a cost regardless of whether it adopts a specific project, so that cost should be counted as a cost of the project.
3.
Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Nevertheless, they must be included in the analysis.
a.
Correct! Incidental cash flows are included in analysis and non-incremental cash flows are not.
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4.
Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Therefore, they must not be included in the analysis.
iv.
How does cannibalization factor into capital investment decisions?
1.
If your company is planning on launching a product, and that product is going to harm the sales of another of your products, it is
better not to compete with yourself and lose market shares.
2.
If your company is planning on launching a product, and that product is going to steal some of the sales of another company’s products, that could be an incidental cost or revenue caused by the new product.
3.
If your company is planning on launching a product, and that product is going to steal some of the sales of another of the company’s products, that loss of sales could be an incidental cost or revenue caused by the new product.
a.
Correct! This is the correct definition of cannibalization.
4.
If your company is planning on launching a product, and that product is going to diminish some of the company’s cash flows generated from another product, it is better not to harm your products’ reputations.
5. Module Summary
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a.
For the capital budgeting process of capital investment, it is essential to consider the time value of money, the risk of a project, and all the cash flows of a project to evaluate whether the project is worthwhile.
b.
The NPV should be used as the primary tool to evaluate projects in conjunction with other capital budgeting criteria that give supplemental information.
c.
The PI is useful to evaluate competing non-mutually exclusive projects with budget constraints.
d.
The time value of money accounts for the opportunity cost of capital investment by making sure that the values of cash flows received at different times are comparable.
e.
The cost of capital accounts for the risk of a project, because investors demand a
certain required rate of return on their investment given the level of risk they have
to take.
f.
It is essential to include incremental cash flows and opportunity costs but not sunk costs to correctly derive the capital budgeting criteria and make a decision.
6.
Module Quiz
a.
A company is considering five projects that are not mutually exclusive. However, the company does not have enough money to do all of them. In order to prioritize
projects that fit within the company’s budget, which capital budgeting method should be used?
i.
Comparing the initial outlay to start with the biggest project
ii.
Internal rate of return (IRR)
iii.
Profitability index (PI)
1.
Correct! The PI should be used first to compare the projects and then to rank them to maximize the value of the firm.
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iv.
Net present value (NPR)
b.
Which scenario is an example of an opportunity cost that is not associated with cash flows?
i.
Charlie stays home all weekend. He did not have any other plans.
ii.
Daisy lost $50 playing poker. Because of this, she decides not to gamble again.
iii.
Bill wants ice cream now. However, he eats dinner first and then buys an ice cream cone.
iv.
Albert decides to stay home and study for his test instead of going to the movies.
1.
Correct! The opportunity cost is going to the movies.
c.
Which condition indicates that an investment will add value to a company?
i.
The positive cash inflows of the project are greater than the negative cash
outflows of the project.
ii.
The future value of the benefits of the investment outweigh the future value of the costs of the investment.
iii.
The present value of the benefits of the investment outweigh the present value of the costs of the investment.
1.
Correct! If the project provides more value than it costs, then mathematically it will add value to the company.
iv.
The opportunity costs of the project outweigh the present value of current operations of the company.
d.
How do corporations and purchasers of financial securities view returns?
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i.
Purchasers of financial securities look at returns as the percentage that they as investors must receive to break even on the money they invested.
ii.
Purchasers of financial securities look at returns as the amount of money they require in order to lend or give their money to the corporation that issued those securities.
1.
Correct! This is a correct description of returns from the viewpoint of investors.
iii.
Corporations look at returns as the risk posed to stockholders and bondholders if a corporation isn’t able to make payments.
iv.
Corporations look at high returns as a cost to investors that prevents them from either lending to or investing in a corporation.
e.
What is an opportunity cost?
i.
The difference between the cost of a project and its potential profit
ii.
The opportunities a company has and how to rank them
iii.
The loss of the ability to use an asset toward the next best project once you have invested it in another project
1.
Correct! The concept of opportunity cost is that because you use an asset to invest in one project, you lose the opportunity to use the same asset to do a different project.
iv.
The cost that must be incurred to make a profit
Unit Summary
1.
In this section, you covered various types of investments and explored methods for evaluating them. For bonds, future cash flows like coupon payments and bond value at
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maturity are discounted using the Yield to Maturity (YTM), representing the required rate of return. Stocks involve estimating future dividends, which are then discounted using the stockholders' required rate to determine stock value. Capital investment demands a thorough examination of cash flows and accurate estimation of the cost of capital based on investors' required rate, influenced by the associated risk. To reinforce your understanding, review key terms and consider real-world applications for the concepts, especially NPV, IRR, and PI, in the context of capital investment and budgeting.
Unit Test
Assessment Section 1
1.
What would an analyst predict for a potential investment with an NPV of zero?
a.
The profitability index would also be equal to zero.
b.
The project would earn exactly the rate of return required by the firm.
i.
Correct! An NPV of zero indicates that a project will neither add nor take away value from a firm.
c.
The project would add value to the firm.
d.
The project would take away value from the firm, but only a small amount.
2.
A financial analyst for the company Bobby’s Books has been asked to evaluate a potential investment using a method that considers the time value of money. Is there more than one way to do this?
a.
No, there are no valuation methods that take into account the time value of money.
b.
Yes, the analyst could use the current ratio and could compare cost of capital rates.
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c.
Yes, the analyst could use both the NPV and the IRR.
i.
Correct! Both NPV and IRR take into account the time value of money.
d.
No, the analyst could only use cash budgeting to evaluate the project.
3.
If two projects are mutually exclusive, which decision-making criterion will help you make
the best decision about which project to accept?
a.
Profitability index (PI)
b.
Internal rate of return (IRR)
c.
Net present value (NPV)
i.
Correct! When only one project can be chosen, the PI is not useful because it does not indicate the dollar value that a project will add to or take away from a firm.
d.
Initial outlay (IO)
4.
Why might a firm prefer to raise debt capital through bonds instead of stocks?
a.
Bonds do not require the firm to pay back its loan.
b.
Bonds have no expiration date.
c.
Bonds do not require a firm to give up any ownership.
i.
Correct! This is attractive to a firm that needs funds for a project but wishes to maintain control.
d.
Bonds take advantage of upside potential.
5.
Why is it appropriate to calculate the value of a bond in the same way that the present value of an annuity is calculated?
a.
Bonds pay a coupon every six months, pay a constant coupon amount, and have
a maturity date.
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i.
Correct! Bond cash flows are an annuity, a constant amount paid every period.
b.
The cash flows that come from owning a bond grow at a constant rate every year, and the payments continue forever.
c.
Even though bonds have a fixed length, the cash flows differ each year.
d.
A bond is a fixed amount paid each period forever to compensate investors.
6.
Why is it important to consider the cost of capital in an ideal evaluation method of capital
investment?
a.
Because if you can receive money earlier, you can reinvest the cash into different
projects earlier
b.
Because the value of a cash flow today is different from the value of a cash flow of the same amount of in 10 years
c.
Because it cannot be determined how a potential project enhances the firm’s value without considering every cash flow of the project
d.
Because cash flows for a project may be uncertain
i.
Correct! This is the reason why you should consider the cost of capital.
7.
What must be determined in order to compare the values of two projects with differently timed cash flows that does not need to be determined for projects with similarly timed cash flows?
a.
Present value of the benefits
b.
Opportunity cost
i.
Correct! Opportunity cost must be determined to analyze two such projects.
c.
Positive cash inflows and negative cash outflows
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d.
Future value of the benefits and future value of the costs
8.
What is the disadvantage of debt financing?
a.
A company with high amounts of debt will have a shorter YTM for its bonds.
b.
Debt financing creates a tax shield disadvantage.
c.
The more debt a company takes on, the less equity it can raise.
d.
Debt financing does not actually achieve an optimal capital structure for a company.
i.
Correct! Debt creates a tax shield, but there should be a mixture of debt and equity in an optimal capital structure.
9.
How do you factor sunk costs into capital investment analysis?
a.
They are inputted as negative cash inflows along with the initial outlay.
b.
They can be added into our analysis, depending on management’s decision.
c.
Sunk costs are subtracted from the opportunity cost and attributed to net cash flow.
d.
For the purposes of analysis, sunk costs are irrelevant.
i.
Correct! Sunk costs are costs that have already been incurred whether you choose to do a project or not.
10. Beckingham Sports is an American sporting goods company. Based on a $400,000 market study and a $600,000 fee for consulting spent prior to the project, the firm can increase its annual operating cash flow by $3,000,000 by selling overseas. Because the firm was considering the expansion, it spent $2,000,000 to purchase a land for new factory and equipment. However, someone is making an offer to pay the company
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$3,000,000 for the land it purchased for the new factory. What is relevant to include in the company’s capital budgeting decision?
a.
$2,000,000 spent to purchase the land
b.
$600,000 for the consulting
c.
3,000,000 for the offer price of the land
i.
Correct! If you do the project, you will miss the opportunity to sell the land for $3,000,000. This is an example of an opportunity cost.
d.
$400,000 spent on the market study
Assessment Section 2
11. Why is NPV the most reliable method for evaluating investments?
a.
It is capable of considering cash flows without taking into account the time value of money, it is useful for comparing two projects of different sizes, and it is an infallible rule for accepting or rejecting capital projects.
b.
It does not require you to estimate the cost of capital.
c.
It makes it easy to estimate the cost of capital, it ignores risk, and it is better for tax purposes.
d.
It considers the time value of money, it tells you the dollar value that the investment will add to the firm, and it takes risk into account.
i.
Correct! These are the main advantages of the NPV, some of which are not included in other methods of valuation, which makes NPV the most reliable.
12. Suppose you are a manager at a firm. One of your financial analysts places a report on your desk of valuation calculations for some potential investment projects. When you look at the calculations later, you notice that the analyst did not indicate if she used the
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NPV or IRR method. However, you do notice that the results of the calculations are all percentages. What can you conclude?
a.
The calculations are incomplete.
b.
The calculations are all wrong.
c.
The analyst used the IRR method.
i.
Correct! IRR calculations are represented as percentages because they are rates of return.
d.
The analyst used the NPV method.
13. You are considering a project that has a profitability index of 1. What does this mean?
a.
The project has a positive net present value.
b.
The project has a negative net present value.
c.
The benefit outweighs the cost of the project by the exact same amount as the initial cost.
d.
The project has the internal rate of return equal to the cost of capital.
i.
Correct! PI = 1 means that the break-even point is the estimated cost of capital; in other words, the cost of capital and the rate of return should be exactly the same.
14. You just purchased a bond for $1,000 that has a par value of $1,000. What type of bond is this?
a.
A premium bond
b.
A preferred bond
c.
A par bond
i.
Correct! The market price of a par bond is the same as the par value.
d.
A discount bond
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15. Why is it appropriate to calculate the value of a preferred stock in the same way that you
would find the present value of a perpetuity?
a.
For a preferred stock, a fixed amount is paid forever to compensate the investors.
i.
Correct! This is the case for preferred stocks, which are a type of perpetuity.
b.
Preferred stocks pay a coupon every six months, the coupon amount is constant,
and the stock has a maturity date.
c.
Even though a preferred stock has a fixed length, the cash flows differ each year.
d.
The cash flows that come from owning a preferred stock grow at a constant rate every year and continue forever.
16. Why is it important to consider the time value of money in an ideal evaluation method for
capital investment?
a.
Because each project has different amount of risk
b.
Because without considering every cash flow of a potential project, you do not know how the project would enhance the firm’s value
c.
Because the value of a cash flow today is different from the value of a cash flow of the same dollar amount in 10 years
i.
Correct! You cannot directly compare dollar amounts received at different times.
d.
Because a project’s cash flows may be uncertain
17. Which scenario correctly describes opportunity cost?
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a.
Caroline makes $25 an hour. Instead of working one night, she goes to a concert that costs $50 and lasts two hours. The opportunity cost of the concert is $50.
b.
Buster buys a pizza and with the same amount of money he could have used to buy a hamburger and fries. There is no opportunity cost because they cost the same.
c.
Alexandra decides to spend $50 on some new clothes instead of using that money to pay her electric bill. The opportunity cost is having the electricity turned
off.
i.
Correct! Because she bought new clothes, she did not pay her bills.
d.
Donatello has a side business making sculptures in addition to his regular job. If he spends more time on his side business, the opportunity cost is the money he makes from selling his sculptures.
18. How does management choose between two projects that are seemingly the same?
a.
If two projects are seemingly the same, it does not matter what choice management makes.
b.
As stated in the reinvestment assumption, there cannot be two projects that are the same.
c.
Management can analyze the different inherent risks that change the cost of capital to the firm.
i.
Correct! Each project will have its own inherent risks.
d.
Management can analyze the effect each project will have on the firm’s overall capital structure.
19. Which term describes the reduction in sales of a company’s own products due to the introduction of another similar product?
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a.
Cost of cannibalization
i.
Correct! The cost of cannibalization is the reduction in sales of a company’s own products due to the introduction of another similar product.
b.
Sunk costs
c.
Opportunity cost
d.
Interest cost
20. Which item is considered a sunk cost?
a.
The required training in order to operate new equipment
b.
The price of selling old equipment that will be replaced by new equipment
c.
The consulting cost spent three months prior to the start of a project
i.
Correct! Since the cost was incurred before the start of the project, this is a sunk cost.
d.
The shipping cost of a new machine for a project
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