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CORPORATE FINANCE EXAM QUESTIONS AND ANSWERS #20
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CORPORATE FINANCE EXAM QUESTIONS AND ANSWERS #20
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CORPORATE FINANCE EXAM QUESTIONS AND ANSWERS #20Overall idea of capital budgeting - correct answer -an investment is worth undertaking if
it creates value for the firm
-an investment worth more than it costs us to take generates value --> what you get
should be more than what you are investing
Net present value - correct answer -the difference between what you earned and what
you spend
-a measure of value added by undertaking the investment --> reflects net gains in
shareholder wealth
-represents the value generated by the investment in todays' money
Calculating npv - correct answer npv = pv(inflows) - pv(cost)
-estimate the expected future cash flows
-estimate the required rate of return for projects of this risk level
-find the present value of cash flows and subtract the initial investment to arrive at the
npv
Npv rule - correct answer accept project if npv > 0
-an investment with a positive npv creates value and should be undertaken
-an investment with a negative npv erases value and should not be undertaken
-an investment with an npv of 0 means it breaks even and should put avoided
Why is npv the most dominant method of capital budgeting - correct answer -considers
all cash flows
-considers the time value of money
-adjusts for the risk of the project
-allows ranking of mutually exclusive projects based on npvs
Mutually exclusive - correct answer picking one prevents you from picking another
Npv and mutually exclusive projects - correct answer compare npvs of projects and
choose the one with the highest npv, aka which will add the most value to the firm
Payback period - correct answer -the length of time it takes to recover the initial
investment in the project
-how long it takes for the revenues of the project to offset initial cost
Calculating payback period - correct answer -estimate cash flows
-subtract the future cash flows from the initial cost until initial investment is recovered
Payback period rule - correct answer accept if the payback period is less than some
present limit (given)
Payback period analysis - correct answer -simple and quick
, -ignores risk and time value of money as well as cash flows beyond the cutoff
-overly rejects project that generate value in the long term
-should be used only as the preliminary screening for projects, as passing this rule just
warrants a further detailed analysis
The internal rate of return (irr) - correct answer -a single rate of return that summarizes
the merits of a project
-rate is fully dependent on the cash flows of the project
-irr = break-even discount rate
Irr and npv - correct answer -the irr on an investment is the discount rate that makes the
npv = 0
-start rejecting projects when npv = 0
-to find the break-even discount rate aka irr, we set npv equal to zero and solve for the
discount rate
Irr rule - correct answer accept the project is the irr > required return
Irr analysis - correct answer -misleading with some cash flows (unconventional) -->
because these flows generate two irrs
-easy to communicate value of a project
-considers all cash flows
-considers time value of money
-provides indication of risk
-cannot pick the best of two mutually exclusive projects bc it ignores size of project
-so unreliable w mutually exclusive projects and unconventional cash flows
Modified internal rate of return (mirr) - correct answer -solves the problem of arriving at
multiple irrs from some cash flows (unconventional)
-the discount rate used = project's required return
Discounting approach for mirr - correct answer whenever a project has cash outflows in
the future (costs)
-calculate the pv of the cash outflow using the discount rate
-modify the cash flows by removing the cash outflow and add it's pv to the initial cost
-calculate the irr of the modified cash flows, which will equal mirr
The profitability index - correct answer -measures the benefit per unit cost, based on the
time value of money
-useful for capital rationing
Profitability index rule - correct answer accept the project if pi > 1.0
Calculating profitability index - correct answer -calculate pv of all future cash flows
-divide by absolute value of initial investment
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