1
Q
What is the payback method used for in capital investment analysis?
A
To calculate the number of periods (years) that must pass before the net after-tax undiscounted cash flows from an investment will equal the initial investment cash outflows.
2
Q
How is the payback period calculated when cash flows are all inflows and are constant over the life of the project?
A
Payback Period = Initial net investment / Periodic constant expected cash inflow
3
Q
What is the decision criterion used for the payback method of capital investment analysis?
A
A company using the payback method chooses its desired payback period.
- Projects with payback periods of less than the chosen amount of time are candidates for further consideration.
- Projects with payback periods greater than the chosen amount of time are rejected.
4
Q
What are the advantages of the payback method of capital investment analysis?
A
- Simple and easy to understand
- Useful for preliminary screening
- Helpful when expected cash flows in later years are uncertain or the company wants to recoup its initial investment quickly
- Favors projects with short time horizons, helpful when the company wants to avoid tying up capital for long periods
- Useful in unstable environments where quick profit-making is preferable
5
Q
What are the disadvantages of the payback method of capital investment analysis?
A
- Ignores cash flows beyond the payback period
- Does not incorporate the time value of money
- Does not consider return on investment
- Does not consider profitability or risk
- Ignores the company’s required rate of return, so the company could accept a project for which it will pay more for its capital than the project can return
6
Q
What is the main limitation of the payback method of capital investment analysis that the discounted payback method addresses?
A
The payback method does not incorporate the time value of money; and the discounted payback method does.
7
Q
How is the discounted payback period calculated?
A
To calculate the discounted payback period:
- Calculate the cumulative discounted expected after-tax net cash flow, including the cash outflow at Year 0.
- The discounted payback period is the number of years (including the fraction of the final year) required for the cumulative discounted expected after-tax net cash flow to become zero.
A discounted cash flow amount is the present value of the future expected cash flow. The present value of a future expected cash flow is calculated using a discount rate that is the company’s required rate of return (RRR).
8
Q
What is the required rate of return as used in capital investment analysis also known as?
A
Discount rate, hurdle rate, or opportunity cost of capital.
9
Q
What is the focus of discounted cash flow methods of capital investment analysis?
A
The focus is on the cash return that can be obtained in the future for an investment made now. The future returns are discounted to reflect the fact that funds received in the future are worth less than they would be if they were received now.
10
Q
What assumption is made about the timing of cash flow receipts in discounted cash flow methods of capital investment analysis?
A
All expected cash flows after the initial cash outflow are assumed to occur at the end of each year.
11
Q
What is the discounted payback period as used in capital investment analysis?
A
The time it takes for the cumulative discounted cash flows from a project to equal the initial investment.
Unlike the payback method, the discounted payback period incorporates the time value of money.
12
Q
What is the net present value (NPV) of a capital investment project?
A
The difference between the present value of all future expected after-tax net cash inflows and the present value of all (initial and future) expected net after-tax cash outflows, using management’s required rate of return as the discount rate.
13
Q
What does a positive net present value (NPV) indicate about a capital investment project?
A
That the project will be profitable and increase shareholder wealth, making it acceptable.
14
Q
What is the interpretation of a zero NPV in capital investment analysis?
A
It means the present value of expected future cash inflows equals the present value of expected cash outflows, providing no motivation to undertake the project.
15
Q
What does a negative net present value signify in capital investment analysis?
A
That a project would be unprofitable, decreasing shareholder wealth, and is not acceptable.
16
Q
What are the relevant expected cash flows in a capital investment analysis?
A
- Initial cash outflow for investment in fixed assets and working capital increase
- Initial after-tax cash inflow from the sale of existing assets at beginning of project
- Cash outflows for follow-up investments
- After-tax incremental operating receipts net of related disbursements
- Cash inflow from the depreciation tax shield
- After-tax cash inflows at disposal or completion of project
- Working capital released at the end of the project
17
Q
How is the NPV calculated for a capital investment project for which the expected future annual cash flows are unequal?
A
- Calculate the relevant net cash outflow for Year 0.
- Discount each subsequent year’s after-tax net cash flow back to Year 0.
- Sum the discounted subsequent cash flow amounts.
- Subtract the Year 0 net cash outflow.
18
Q
How is the NPV calculated for a capital project for which the expected future annual cash flows are equal?
A
The present value of the subsequent expected after-tax net cash flows can be discounted as an annuity, and the NPV is the present value of the subsequent expected cash flows minus the initial investment.
19
Q
How is NPV calculated for a capital investment project with equal subsequent annual cash flows but with one unequal amount at the end?
A
Discount the equal net cash flows as an annuity, discount the unequal net cash flow as a single amount, sum the two discounted amounts and subtract the initial investment to find the NPV.
20
Q
What is a perpetual annuity?
A
A stream of equal cash flows that continues indefinitely.
21
Q
How is the present value of a perpetual annuity calculated?
A
The present value of a perpetual annuity is the annual after-tax net cash inflow divided by the required rate of return.
The annual after-tax cash inflow divided by the required rate of return is the Zero Growth Dividend Model.
22
Q
How is the net present value calculated for a capital investment project with perpetual subsequent cash flows that are all equal?
A
The present value of the annual after-tax net cash inflows minus the initial investment.
The present value of a perpetual annuity is the annual after-tax cash inflow divided by the required rate of return.
23
Q
How is the present value of a perpetual growing annuity calculated?
A
By dividing the annual after-tax net cash flow at the end of the first year by the difference between the required rate of return and the growth rate.
This method is similar to the Dividend Growth Model used for valuing common stock with growing dividends.
24
Q
How is the net present value calculated for a capital investment project with a perpetual growing annuity as the subsequent cash flows?
A
The net present value of the project is the present value of the subsequent annual cash flows minus the initial investment.
The present value of a growing annuity is calculated by dividing the annual after-tax net cash inflow at the end of the first year by the difference between the required rate of return and the growth rate.
25
What is the importance of the discount rate in calculating the net present value of a capital investment project?
The discount rate, or the required rate of return, is used to discount the expected subsequent cash flows from the project in the NPV calculation.
A company should invest money in a project only if the project provides a return higher than its required rate of return, that is, the NPV calculated should be positive. Doing so will increase the value of the company and stockholder wealth.
## Footnote
The usual measure of the required rate of return is a company’s weighted average cost of capital (WACC).
26
The weighted average cost of capital (WACC) is the appropriate discount rate for NPV calculations and other capital investment analyses **if the market risk of the project is the same as the average market risk of the company's existing projects.**
What conditions must be met for the WACC to be used without adjustment for a given capital investment project?
* The new project must not substantially change the company’s or business unit's current market risk.
* New capital must be raised in the same proportions as existing capital, so that the company’s or business unit’s financial risk remains the same.
27
What is the weighted average cost of capital (WACC)?
WACC is the opportunity cost of capital for a company’s existing assets, calculated as the weighted average of the costs of each capital component in the capital structure.
28
What is the decision criterion used when evaluating the net present value (NPV) of a capital investment project?
* A project with a positive NPV is acceptable as it will increase shareholder wealth.
* A project with a negative NPV is not acceptable.
## Footnote
However, due to limited funds or nonfinancial factors, not all projects with positive NPVs may be chosen.
29
What assumption does the NPV method of capital investment analysis incorporate regarding reinvestment of the subsequent cash flows from a project?
The NPV method incorporates an assumption that all after-tax net cash inflows from the project will be reinvested at the required rate of return for the project.
30
What is a disadvantage of the fact that the NPV of a capital investment project is expressed as a monetary amount?
Since the NPV is expressed as a monetary amount, it does not provide an expected rate of return on the investment.
31
What is the effect of the discount rate used on the NPV of a capital investment project?
The higher the discount rate used, the lower the NPV; and the lower the discount rate used, the higher the NPV.
32
What is the NPV profile of a capital investment project?
It is a graph showing the relationship between various discount rates and the project’s net present values at each rate.
33
What are the **advantages** of the NPV method of capital investment analysis?
* Provides an estimate of project profitability and shareholder wealth change.
* Considers the time value of money.
* Incorporates all project cash flows
* Can be used to manage and compensate for systematic risk by adjusting the discount rate and for unsystematic risk by adjusting the expected cash flows
* Enables ranking of projects by expected monetary returns
* Cash flows used can be discounted individually by component or by period.
34
What are the **disadvantages** of the NPV method of capital investment analysis?
* Assumes reinvestment of cash inflows at the required rate of return.
* Does not provide an expected rate of return.
* Sensitive to incorrect assumptions and discount rate estimation.
* Does not recognize cash flows beyond the project’s expected lifetime.
* The company’s actual cost of capital may vary significantly from the discount rate used in the NPV analysis
35
What is the internal rate of return (IRR) for a capital investment project?
The discount rate at which the present value of the project's expected after-tax net cash inflows equals the present value of its expected after-tax net cash outflows.
## Footnote
It is the discount rate at which the project's NPV is equal to zero.
36
How is a capital investment project's internal rate of return (IRR) calculated when all the expected subsequent annual cash inflows from the project are equal?
1. Divide the net initial investment by the annual after-tax net cash inflow to calculate a factor.
2. In a PV of an Annuity factor table, on the line for the number of years of the project’s life, locate the factor closest to the one calculated in Step 1. The rate at the top of the column is the rate of return closest to the project’s internal rate of return.
3. If the factor calculated in Step 1 falls in between two rates on the factor table, use interpolation to estimate the IRR.
37
How is a capital investment project's IRR calculated when the annual after-tax net cash flows are not the same for every year of the project’s life?
The IRR can be found by calculating the project's NPV using various trial rates and interpolating until finding the rate where the NPV is zero or closest to zero.
## Footnote
The IRR can also be calculated using a financial calculator.
38
How is the internal rate of return (IRR) evaluated in capital investment analysis?
The IRR of a project is compared with the project's hurdle rate to determine if the project is acceptable.
* If the project's IRR is higher than the required rate of return, the project is acceptable.
* If the project's IRR is lower than the required rate of return, the project should not be considered further.
39
What is the reinvestment assumption in the internal rate of return method of capital investment analysis?
Cash inflows from the project are assumed to be reinvested at the internal rate of return.
40
What is the problem with the reinvestment assumption in the internal rate of return method of capital investment analysis?
The reinvestment assumption in the IRR is that cash inflows from the project will be able to be reinvested at the internal rate of return.
However, future cash inflows from the project may not be able to be reinvested at the project's IRR.
41
What is the modified IRR method of capital investment analysis?
The modified IRR assumes cash flows are reinvested at the company's cost of capital.
42
What is a conventional capital investment project in terms of cash flows?
A conventional project begins with a net cash outflow followed by several net cash inflows.
The direction of the cash flow changes just once, from negative in Year 0 to positive in Year 1, and it remains positive throughout the remainder of the project’s life.
43
What is an unconventional capital investment project in terms of cash flows?
It is one where subsequent cash flows alternate between positive and negative over its life.
Instead of the initial cash outflow being followed by several years of net cash inflows, subsequent cash flows for an unconventional project include some years of net cash inflows and some years of net cash outflows,
44
What can cause **multiple IRRs** for a capital investment project?
Multiple IRRs can occur whenever the sign of the expected net cash flows changes more than once during a project’s life, because more than one discount rate will cause the project’s NPV to be zero.
45
What is the maximum number of IRRs a capital investment project can have?
Equal to the number of reversals of the sign in the net cash flows.
46
Why might IRR not be useful for mutually exclusive capital investment projects?
If mutually exclusive projects being considered are of different sizes or have different lives or cash flow patterns, the IRR is not reliable and comparisons using the IRR can be misleading.
47
What is the **crossover rate** in capital investment analysis?
The unique discount rate where the NPVs of two capital investment projects are the same.
48
What are the **advantages** of the IRR method of capital investment analysis?
* The IRR accounts for the time value of money
* The IRR can be compared with a required rate of return chosen by management
* It is easier for managers to understand and interpret than net present value
49
What are the **disadvantages** of the IRR method of capital investment analysis?
* The assumption that the cash inflows from the project will be reinvested at the internal rate of return, which may not be the case
* May not be usable if a project has a negative cash flow or flows after Year 0 because the project may have more than one IRR or it may not be possible to calculate the IRR
* When investments are mutually exclusive and are of different sizes or have different cash flow patterns, the IRR may not be useful for decision making
50
What is the significance of the point where a capital investment project's NPV profile line crosses the horizontal axis?
The point where the NPV profile line crosses the horizontal axis—where the NPV is zero—is the project’s IRR.
51
How should **interdependent** capital investment projects be evaluated?
Acceptance of a capital investment project that is interdependent with another project or projects requires the acceptance of the other project or projects also.
Projects that are interdependent must be evaluated together and either all accepted or all rejected.
52
In capital investment analysis, what are differential cash flows?
Differential cash flows are the **difference** in cash flows between two alternatives that would result from choosing one option over another, and they are relevant factors in decision-making.
## Footnote
Example: A differential capital investment analysis can be used to decide whether to continue using an old asset or replace it with a newer asset, by calculating the difference in cash flows.
53
What are the relevant cash flows in a differential capital investment analysis for replacing an asset?
* After-tax salvage value of the old asset at the inception of the project if it will be disposed of
* After-tax salvage value of the new asset at the end of its useful life
* Difference in the depreciation tax shield for each year
* If the old asset would have had a salvage value at the end of its life if not replaced, the loss of the after-tax salvage value at the end of the old asset’s life if it is sold now and the new asset is purchased.
* Differential change in after-tax operating cash receipts net of cash disbursements
54
What is the impact of inflation on capital investment analysis?
Inflation causes a decline in general purchasing power over time, affecting the analysis of long-term projects.
55
What is the difference between nominal and real cash flows in a capital investment analysis?
* Nominal cash flows include inflationary increases.
* Real cash flows do not include inflationary increases.
56
What is the formula used to convert nominal cash flow to real cash flow for use in a capital investment project analysis?
Real expected cash flow = Nominal cash flow / (1 + inflation rate)*n*
## Footnote
Where *n* is the number of years from Year 0
57
What is the formula used to convert a nominal required rate of return to a real required rate of return for use in a capital investment project analysis?
Real required rate of return = [(1 + Nominal rate) / (1 + Inflation rate)] − 1
58
What is the formula used to convert a real required rate of return to a nominal required rate of return for use in a capital investment project analysis?
Nominal required rate of return (RRR) = [(1 + Real RRR) × (1 + Inflation rate)] − 1
59
What is the formula used to convert real expected cash flow to nominal expected cash flow for use in a capital investment project analysis?
Nominal expected cash flow = Real expected cash flow × (1 + inflation rate)*n*
## Footnote
Where *n* is the number of years from Year 0
60
What are the components of the **real** required rate of return for a capital investment project?
* The risk-free rate of return
* A market risk premium
## Footnote
The risk-free rate of return assumes no inflation.
61
What are the components of the **nominal** required rate of return for a capital investment project?
* The risk-free rate of return
* A market risk premium
* An inflation element
## Footnote
The first two components are the components of the real rate of return. The inflation element is a premium above the real rate to offset the expected decline in purchasing power due to inflation.
62
# True or False:
The nominal required rate of return for a capital investment project is simply the sum of the real required rate and the inflation rate.
False
## Footnote
The nominal required rate of return is slightly higher than the sum of the real required rate and the inflation rate because inflation decreases the purchasing power of both the principal and the real rate of return earned each year.
63
# True or False:
When incorporating inflation into a capital investment analysis that is based on real cash flows and required rate of return, both the expected net real cash flows and the real required rate of return should be adjusted to nominal values.
True
## Footnote
Both must be adjusted to nominal values to accurately reflect inflation in the analysis. The nominal required rate of return should be used to determine the present value of the annual nominal expected cash flows.
64
In capital investment analysis, when should the NPV be relied on over the IRR, if the two are in conflict?
* Unconventional projects
* Scale differences of the projects
* Cash flow timing differences of the projects
* Different reinvestment rate assumptions used by NPV and IRR
* Variation in project lives
## Footnote
NPV is more reliable for maximizing shareholder wealth, especially when IRR and NPV provide conflicting information.
65
# Fill in the blank:
Expected cash flows for a capital investment project must be determined on an \_\_\_\_\_\_\_\_\_\_\_\_ basis.
after-tax
## Footnote
This ensures that the analysis reflects the actual cash flows available to the company.
66
What is the depreciation tax shield as used in a capital investment analysis?
It refers to the reduction in tax liability during each year of a capital investment analysis due to depreciation expense on the fixed assets used in the project.
## Footnote
Though depreciation is a non-cash expense, it reduces taxable income, resulting in a cash inflow in the form of lower income taxes.
67
How do NPV and IRR account for systematic and unsystematic risk in a capital investment project?
* By adjusting the required rate of return to compensate for systematic risk
* By adjusting the expected cash flows to compensate for unsystematic risk
68
In capital investment analysis, what does the NPV of a project provide an estimate of?
An estimate of the profitability of a project and the amount of change in shareholder wealth that is expected to take place if the project is undertaken.
69
When might the IRR not be useful in a capital investment analysis?
* If a project does not follow the form of a conventional project, since that could cause multiple IRRs
* When projects are of different sizes or have different cash flow patterns
* When capital investment constraints exist
70
What are the assumptions of NPV regarding cash flows in capital investment analysis?
* Cash flows are assumed to be reinvested at a rate equal to the discount rate.
* Initial investment occurs at Year 0.
* Subsequent cash flows occur at the end of each period.
71
What is the role of expected values in capital investment analysis?
They are used as projections of future cash flows.
## Footnote
Expected values are weighted averages of all possible outcomes, with the probabilities of each possible outcome serving as the weights.
72
How can risk be measured for an investment?
By the dispersion or variability of its potential returns around their mean, using variance and standard deviation.
## Footnote
The mean is the weighted average of the potential returns, that is, the expected value, using the probabilities of the potential returns as the weights.
73
What is sensitivity analysis used for in capital investment analysis?
To determine how cash flows are expected to vary with changes in underlying assumptions while changing one assumption at a time.
74
What is present value breakeven analysis?
It determines the number of units a company must sell to achieve a net present value of zero for a project.
75
What is the margin of safety in present value breakeven analysis?
The excess amount of actual or planned sales over the breakeven level of sales.
76
What is the purpose of scenario analysis in project evaluation?
To analyze NPVs and/or IRRs under a series of specific scenarios based on macroeconomic, industry-specific, and company-specific factors.
## Footnote
The decision to accept or reject the project is based on the NPVs and IRRs under all the scenarios, not just one.
Scenario analysis helps in making decisions based on multiple potential outcomes rather than a single estimate.
77
What is the main advantage of simulation analysis over sensitivity analysis?
Sensitivity analysis involves changing just one assumption at a time. Simulation analysis allows for more than one uncertain element in the analysis, providing a comprehensive view of possible outcomes.
## Footnote
Simulations use statistical methods to compute NPVs and IRRs for various outcomes, summarizing results into statistics like average and variance for all the statistics across all the simulation runs. The decision to accept or reject the project is based on the NPVs and IRRs under all the scenarios, not just one.
78
# True or False:
Monte Carlo simulation is used to develop probabilities of various scenarios by generating random values for probabilistic inputs.
True
## Footnote
Monte Carlo simulation uses repeated random sampling to approximate expected values and assess scenario probabilities.
79
What are the **benefits** of using simulation in project analysis?
* Flexibility for a wide variety of problems
* Ability to study interactive effects of variables
* Ease of understanding
* Implementation without special software
## Footnote
Simulations can be used for "what-if" situations and are supported by most spreadsheet packages.
80
What is market, or systematic, risk in capital investment analysis?
Risk that all companies that are sensitive to the business cycle are subject to. Systematic risk is non-diversifiable.
## Footnote
Market risk affects a company's business based on economic activity and is considered when determining the appropriate hurdle rate for investments.
81
When should the required rate of return (RRR) for a project be increased?
When the market, or systematic, risk of a project is greater than the market risk of the company’s or business unit’s present portfolio of investments.
## Footnote
A higher required rate of return accounts for increased market risk, requiring higher expected future cash flows for investment acceptance.
82
What factors determine the sensitivity of a project's earnings to the business cycle?
* Sensitivity of sales to business conditions, a function of the industry in which the company operates
* Operating leverage of the business, or the proportion of fixed costs in the cost structure of the project
* Financial leverage of the business, or the proportion of debt in the project’s capital structure
## Footnote
These factors influence how earnings respond to economic changes, affecting the project's market risk.
83
What is operating leverage and how does it affect the market risk of a capital investment project?
It refers to the degree to which a project or company uses fixed costs in its cost structure. Higher operating leverage means higher market risk due to greater sensitivity to changes in demand.
## Footnote
Projects with greater amounts of variable costs in their cost structures will be less sensitive to the business cycle and have less market risk because costs can be reduced more easily if demand falls in response to lowered economic activity.
84
How does financial leverage affect a project's risk?
Financial leverage increases a project's financial risk and sensitivity to the business cycle due to the fixed nature of interest payments on debt.
## Footnote
A higher proportion of debt in a project's capital structure increases the possibility of insolvency.
85
What is non-market or unsystematic risk?
Risk that is specific to an individual investment project and is diversifiable.
## Footnote
Examples include the risk of a new drug not being approved or a new technology not working.
86
How should expected cash flows be adjusted for non-market risks?
They should be decreased for projects with greater non-market risk and increased for projects with less non-market risk.
## Footnote
This adjustment reflects the likelihood of unfavorable outcomes specific to the project.
87
What is the **Capital Asset Pricing Model** (CAPM) used for in capital investment analysis?
CAPM is used to estimate a risk-adjusted required rate of return for a project based on its systematic risk.
## Footnote
The model uses the risk-free rate, a beta coefficient, and the market's required rate of return.
88
# Fill in the blanks:
The formula for the CAPM is R = Rf + β(Rm − Rf), where R is the required rate of return, Rf is the risk-free rate, and Rm is the \_\_\_\_\_\_\_ \_\_\_\_\_\_ \_\_\_ \_\_\_ \_\_\_\_\_\_\_.
expected return on the market
89
What unique advantage does the Net Present Value (NPV) of capital investment analysis have over other methods of analysis?
It allows cash flows to be discounted individually by component or by period, providing flexibility in reflecting different levels of systematic risk.
## Footnote
This flexibility is not available with other capital investment analysis methods.
90
What is the purpose of a post-completion audit?
It compares the actual benefits and costs of projects with the original estimates to provide feedback and improve future capital investment analyses.
## Footnote
It introduces discipline and control into the capital investment analysis process.
91
How is the profitability index calculated in capital investment analysis?
Profitability Index = PV of Future Cash Inflows / (Initial Investment + PV of Future Cash Outflows)
## Footnote
It is a benefit/cost ratio representing the ratio of the present value of benefits to the present value of costs of a project.
92
What is the real options approach in capital investment?
Real options allow for modifying projects based on new information, offering flexibility such as the option to abandon or expand a project, thereby adding value beyond the basic NPV approach.
The real options approach considers the flexibility to modify a capital investment project as analogous to holding an American call option.
93
What are some common real options in capital investment?
* Option to make follow-on investments
* Option to abandon a project
* Option to delay a project
* Option to vary inputs, production methods, or output mix
94
What is the bailout payback method used for in capital investment analysis?
It is a variation of the payback method that can be used to quantify a real option to abandon a project by including the after-tax salvage value of project assets that would result upon termination of the project at various dates.
95
How is the value of a real option on a capital investment project determined?
By calculating the NPV of the project without the real option, then with the real option, and finding the difference.
96
How can Monte Carlo analysis be used to determine a capital investment project’s NPV with real options?
By building all the possible payoffs under the real options into the Monte Carlo analysis model. The result is an averaged approximate NPV with the real options.
97
What are some qualitative factors that might influence capital investment decisions?
* Enhance product and service quality
* Shorten production and delivery time
* Address consumer safety concerns
* Respond to regulations or environmental concerns
* Improve worker safety
* Raise public relations image
* Improve community welfare
* Reflect personal wishes of management
CMA® Part 2
flashcards
Decks in class (19)
# Cards
-
A.1. Comparative Financial Statement Analysis11
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A.2. Financial Ratio Analysis150
-
A.3. Profitability Analysis37
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A.4. Advanced Financial Topics60
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B.1. Risk and Return Fundamentals57
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B.2. Long-Term Financial Management124
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B.3. Raising Capital and Financial Markets38
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B.4. Working Capital Management105
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B.5. Corporate Restructuring and Valuation39
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B.6. International Finance68
-
C.1. Cost-Volume-Profit (CVP) Analysis52
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C.2. Marginal Analysis and Decision Making57
-
C.3. Pricing Decisions86
-
D.1. Enterprise Risk Management (ERM)80
-
E.1. Capital Investment Analysis and Cash Flows34
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E.2. Capital Investment Methods and Risk97
-
F.1. Business Ethics and Fraud30
-
F.2. IMA Code of Ethics and Fraud Triangle14
-
F.3. Organizational Ethics and Culture64
