5. Measuring Return on Investments
1. What determines the required rate of return on a project? How can we estimate the required rate of return on a project?
Determined by the risk of the project
Estimated by: If taking a project that does not affect firm’s risk, then use WACC
If not, estimate cost of equity (unlevered) (unlevered = without the debt)
2. What are the differences between accounting earnings and cash flows?
You shouldn’t use accounting earnings because can manipulate. Includes income statement, sales, COGS, profit.
Cash flows = earnings before interest and taxes + depreciation + increase in assets – increase in Accounts Payable – variation in capital expenditures
-Do an example
3. How can we estimate cash flow to firm from earnings?
4. What are incremental cash flows? Why are they important?
Incremental cash flows = cash flows of the firm with the project – cash flows of the firm without the project (difference between cost if take proj and not take, additional cash flows if take a project)
Include: sunk costs, opportunity costs, side effects of projects
Important because regardless will have sunk costs. Ex: cost to valuate the project. Also, it will be the original CF that is gone, shows the difference between the cash flows and helps decide whether to take the project
5. What are sunk costs? How do we use them when estimating the NPV of a project?
Costs that have already incurred before the project. Irrelevant to the decision of accepting the project. Don’t INCLUDE!
6. What are opportunity costs? How do we use them when estimating the NPV of a project?
The option foregone. Include when estimating NPV.
7. What are the side effects of a project? How do we use them when estimating the NPV of a project?
Side effects will affect other project cash flows. Incremental cash flows help estimate. These will be affect if you accept the project or not.
8. Explain payback method. What are the disadvantages of this method?
Shows how many years it will take to get money back from investment in project.
Disadvantages: not very precise, does not take into account the TVM or cash flows after the cut off period
9. What is the net present value (NPV)? What is the main advantage of this method?
--the present value of the project’s incremental cash flows, helps show what the company value is today. Most consistent with the goal to maximize shareholder wealth. Helps decision be made. If positive, shows that project should return positive.
Company value increased in the future because of the project. You maximize shareholder wealth
10. What is the internal rate of return (IRR)?
Yield on an investment (return). It is the discount rate where NPV = 0. Take project if IRR > the original discount/return rate.
When have more than one change in sign for cash flows, IRR is not reliable.
11. What is the net present value profile?
An abbreviation for net present value profile. An NPV profile charts the net present value of a business activity as a function of the cost of capital. This comparison allows decision-makers to determine the profitability of a project or initiative in different potential financing scenarios, enabling more effective cost-benefit planning.
A graph of the NPVs of a project at different discount rates. (zero, appropriate (given), and IRR). Shows that NPV is dependent on IRR.
13. What are the two problems with IRR?
a. Can be multiple if change sign more than once
b. Can give incorrect answer for mutually exclusive projects (sometimes when looking at two projects, the NPV tells you to do one thing while the IRR says another. When comes down to that, choose one with larger NPV (max SH wealth))
Does not focus on maximization of shareholder wealth
14. What does the stand-alone principle mean? What should we do when it is violated?