Term
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Definition
| All entities require financing from outside sources to carry on day-to-day operations; this usu. takes on the form of spontaneous financing in the form of trade credit offers by vendors, or bank loans. |
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Term
| capital budgeting requirements (IDPR) |
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Definition
Companies must:
Identify appropriate projects,
Determine level of required resources,
Predict expected amounts and timing of returns, and
Rank the desirability of alternative projects. |
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Term
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Definition
| If a supplier offers an early payment discount, it is usually to the entity's advantage to avail itself of the discount. |
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Term
| amortized cost of not taking a discount |
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Definition
| Amortized cost of not taking a discount =[discount % / (100% - discount %)] * [days in year / (total payment period – discount period)] |
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Term
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Definition
| note that must be repaid by a definite time |
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Term
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Definition
| allows the company to continuously reborrow amounts up to a certain ceiling, as long as certain minimum payments are made each month |
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Term
| simple interest short-term loan |
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Definition
| one in which the interest is paid at the end of the loan term; the amount of interest to be paid is based on the nominal (stated) rate and the principal of the loan (amount repaid) |
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Term
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Definition
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Term
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Definition
| effective rate = interest expense (interest to be paid) / usable funds (net proceeds) |
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Term
| Which is higher- the effective or the stated rate? |
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Definition
The effective rate is higher than stated rate b/c net proceeds are lower than the principal.
The borrower gets use of a smaller amount, the effective rate on a discounted loan is higher than its nominal rate. |
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Term
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Definition
| one in which the interest and finance charges are paid at the beginning of the loan term |
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Term
| total borrowings (on discounted loan) |
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Definition
| amount needed / (1.0 – stated rate) |
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Term
| effective rate on discounted loan |
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Definition
| stated rate / (1.0 – stated rate) |
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Term
| loans with compensating balances |
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Definition
| bank sometimes requires borrowers to maintain a compensating balance during the term of a financing arrangement |
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Term
total borrowings (on loan with compensating balances)
effective rate on loan w/compensating balances |
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Definition
amount needed / (1.0 – compensating balance %)
stated rate / (1.0 – compensating balance %) |
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Term
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Definition
process of planning and controlling investments for long-term projects.
Capital projects affect multiple periods and related decisions are inflexible and constrain budgets for multiple years and involve substantial expenditures. |
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Term
| When is capital budgeting used? |
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Definition
| not used if the project will not affect cash flows, the acquisition of long-term assets, or not concerned with financing |
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Term
| Why is capital budgeting/planning so critical? |
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Definition
| b/c of uncertainties about capital markets, inflation, interest rates, and the money supply. |
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Term
| capital budgeting applications |
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Definition
| buying equipment, building facilities, acquiring a business, development of product or product line, expanding into new markets, replacement of equipment. |
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Term
| first step in assessing desirability of capital project |
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Definition
identify relevant cash flows, which do not include sunk costs.
Relevant cash flows include new equipment, annual after-tax cash savings or inflows, salvage value of old equipment, adjustment for depreciation expense on new equipment (depreciation tax shield). |
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Term
| accounting rate of return |
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Definition
| (annual cash inflow – depreciation) / initial investment |
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Term
| Who uses the accounting rate of return? |
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Definition
| Preferred by shareholders and financial analysts b/c GAAP-based numbers are readily available. |
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Term
| disadvantages of accounting rate of return |
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Definition
Ignores TVM.
The true rate of return is not a bookkeeping-based number.
This calculates the aggregate book return for all projects, not breaking down the profitability of individual projects.
Least useful for evaluating capital projects. |
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Term
| discounted cash flow (DCF) analysis |
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Definition
| discounts the relevant CFs using the required rate of return as the discount/hurdle rate/opportunity cost of capital. |
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Term
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Definition
| PV of net cash savings or inflows over life of project – required dollar investment |
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Term
| NPV (positive, negative, 0) |
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Definition
+NPV = do project.
-NPV = don't do it.
NPV of $0 = satisfies exactly the required rate of return. |
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Term
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Definition
| NPV usage assumes that cash flows are reinvested at the minimum required rate of return (WACC). |
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Term
| selecting the appropriate hurdle rate (3 things to adjust) |
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Definition
adjust for inflation (upward as future FCFs consist of inflated dollars),
adjust for risk (riskier projects have higher hurdle rates), and
division-specific rates of return (if one hurdle rate is used for whole firm, high-risk divisions over-invest and need higher hurdle rates while low-risk divisions under-invest and need lower hurdle rates). |
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Term
| internal rate of return (IRR) |
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Definition
| discount rate at which NPV = 0. |
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Term
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Definition
IRR > hurdle rate: accept.
IRR < hurdle rate: reject. |
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Term
| higher hurdle rate vs. lower hurdle rate. |
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Definition
higher risk and must pay off more quickly.
Entities with low hurdle rates prefer a slow and steady payback. |
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Term
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Definition
At hurdle rates where both projects have the same NPV, NPV is the same.
At hurdle rates below that rate, project whose inflows last longer is the better investment.
At hurdle rates above that rate, project whose inflows are front-loaded is better. |
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Term
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Definition
Both methods give the same accept/reject decision if projects are independent (independent projects have unrelated CFs).
If projects are mutually exclusive, NPV and IRR methods may rank them differently if project costs are different, cash flows are different, useful lives are different, and if multiple investments are involved (NPV is better for this one).
IRR assumes that cash flows are reinvested at the IRR, while NPV assumes that cash flows are reinvested at the WACC/required rate of return. |
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Term
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Definition
# of years required for net cash savings or inflows to equal the original investments
payback period = initial investment / annual after-tax cash savings/inflows. |
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Term
| advantages of payback period |
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Definition
| Very simple; the longer the period, the riskier the investment. |
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Term
| disadvantages of payback period |
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Definition
No consideration for TVM and disregards all cash inflows after the payback cutoff date (ignoring total project profitability), which results in accepting many marginal projects and rejecting good ones.
Must decide the acceptable payback period.
If CFs are non-constant, the calculation must be in cumulative form. |
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Term
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Definition
| Net CFs in denominator are discounted to calculate the period required to recover the initial investment. |
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Term
| adv. and disav. of discounted payback |
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Definition
| Acknowledges TVM, but loses the simplicity of the payback method and still ignores CFs after the arbitrary cutoff date. |
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Term
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Definition
| time required for DCFs to equal the initial investment |
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