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Basic Capital Budgeting

The document outlines the major topics and basic problems that will be covered on an upcoming test. It provides details on capital budgeting, cash flows and NPV, mergers and restructuring, options and leasing, financial analysis and planning, and stock and bond financing. For each topic, it lists the basic problems students should know how to solve and explains that complex problems may require using multiple basic formulas. It emphasizes concentrating first on the basic problems in each area and then considering more complex problems if there is time.

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saad bin sadaqat
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35 views

Basic Capital Budgeting

The document outlines the major topics and basic problems that will be covered on an upcoming test. It provides details on capital budgeting, cash flows and NPV, mergers and restructuring, options and leasing, financial analysis and planning, and stock and bond financing. For each topic, it lists the basic problems students should know how to solve and explains that complex problems may require using multiple basic formulas. It emphasizes concentrating first on the basic problems in each area and then considering more complex problems if there is time.

Uploaded by

saad bin sadaqat
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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SECOND TEST -- OUTLINE

There is a good deal of material covered in this section of the class. Therefore, concentrate on knowing how
to solve the basic problems in each of the areas below and then if you have time consider the more complex
problems. The basic problems in the areas listed below will make up most of the test.

Major topics

Basic Capital Budgeting

1. Know how to calculate and use the various project (investment) accept/reject criteria: payback,
IRR, NPV.

2. Know the advantages and disadvantages of each criteria.

3. Know why the net present value method is the theoretically preferred criteria.

4. Know why IRR and NPV sometimes give conflicting results and why NPV is preferred.

5. How to handle projects with unequal lives


- Equivalent annual NPV method - easiest method
- could also use IRR, replacement chains, or assume long life project is sold at end of short
life project

6. Capital rationing deciding among projects when capital is limited


- Maximize total NPV offered by projects subject to budget constraint - profitability index
may help rank projects

Cash Flows and NPV

1. Know how to calculate cash flow after tax including initial, operating and terminal cash flow.
This implies you can calculate depreciation.

2. Know how to handle opportunity costs.

3. Replacement projects - when to accept or reject


- must estimate incremental cash flows including the change in working capital and the tax
and timing effects of disposing of the old project early.

4. Modernization of old project


- treated as a combination of new and old projects rather than the new substitute for old

5. Abandonment of old projects

6. Interrelated projects
- if deciding whether to accept a new project the effects on old projects' cash flows must be
considered - either positive or negative
7. Sequential analysis should be used if project contains different phases with different risks
- use higher k for riskier phase

8. Sensitivity analysis - helpful if estimates of CFs, k, investment, or, project life are uncertain.

9. Financial break-even analysis - estimate break-even sales from a present value perspective
Mergers and Restructuring

1. Calculate NPV for a merger prospect - note differences with cash or stock offers.

2. Be able to calculate pre- and post-merger EPS, P/Es, book value per share, and share price.

3. Calculate NPV for a divestiture or liquidation - much like abandonment decision

Options and Leasing

1. Know what call and put options are and be able to identify them in given a particular situation.

2. Calculate call and put values using Black-Scholes model and put-call parity.

3. Know how to adjust the NPV when a project contains an option or can be delayed.

4. Determine the minimum before-tax lease payment

5. Calculate the net advantage of leasing (an NPV of a lease) and know how to use it in deciding
whether to lease or buy.

Financial Analysis and Planning

1. Know how to analyze a firm's financial condition


-liquidity, asset and debt management, profitability ratios
-analysis of ROE components - DuPont analysis

2. Know how to analyze a statement of cash flows.

3. Know how to construct a cash budget.

4. Know how to construct pro-forma financial statements.

Stock and Bond Financing

1. Know the process for underwriting

2. Know which types of financing are appropriate for given conditions.

3. Know how to calculate offering prices for stock and bonds.

Finally, you should know how to explain each of the problems. That is, not only show that you know when
to use the formulas, but also how to interpret the results. Complex problems usually involve more than one
basic formula.

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