11 Capital Budgeting

Question 1

What are the steps of the capital budgeting process?

Answer 1

1. identify investments
2. determining the resources required
3. projecting the expected amounts of timing of returns
4. ranking the identified investments

Question 2

What is capital budgeting?

Answer 2

The process of planning and controlling investments for long-term projects.

Question 3

What are screening decisions?

Answer 3

The screening decision examines all potential projects and determines whether each of them meets a predefined criterion or hurdle. Ex - a screening criterion for a business could be a required return on investment of at least 15% to accept a project.

Question 4

What is are preference decisions?

Answer 4

The preference decision ranks all the acceptable projects identified in the screening phase and selects from only the acceptable projects. The ranking or preference decision is sometimes referred to as capital rationing. Ex - assume 7 projects meet a firm’s screening criteria during the screening decision. The total investment required for all 7 projects is $5 million, but the firm only plans to invest in $2 million, the preference decision determines how the firm ranks the potential projects to ration the use of the limited investment funds.

Question 5

What are relevant cash flows?

Answer 5

Future uncertain cash flows. Relevant cash flows do not include sunk costs, those already paid or irrevocably committed to be paid.

Question 6

What are operating cash flows?

Answer 6

The annual after-tax cash savings or inflows.

Question 7

What is depreciation tax shield?

Answer 7

The amount by which depreciation shields or protects the taxpayer from income taxes. It is calculated by multiplying the applicable tax rate by the amount of depreciation (depreciation expense x tax rate).

Question 8

How is operating cash flows calculated?

Answer 8

after-tax annual cash flows can be calculated in two different ways

operating cash income net of taxes + depreciation tax shield = after-tax cash flow

[operating income x (1 - tax rate)] + depreciation expense = after-tax cash flow

Question 9

How do you calculate free cash flow?

Answer 9

free cash flow = operating cash flow - net capital expenditure - net change in working capital

Question 10

What is the difference between simple and compound interest?

Answer 10

Simple is when the investors receive the interest payments in cash after the end of the period. Compound is when the investor’s interest payment is added to the principal balance, which accrues more interest each year.

Question 11

What is the formula for accounting rate of return?

Answer 11

accounting rate of return = (annual cash inflow - depreciation) / initial investment

Question 12

What are some limits to the usefulness of accounting rate of return for selecting capital projects?

Answer 12

Accounting rate of return is affected by the accounting methods chosen:

• accountants must choose which expenditures to capitalize and which to expense immediately
• they choose how quickly to depreciate capitalized assets
• a project’s true rate of return cannot be dependent on such decisions
• the accounting rate of return does not take into account the time value of money
• the accounting rate of return is not useful for projects in which the investments are made in multiple installments at different times
• the accounting rate of return fails to consider increased risk of long-term projects. Ex - a project with a 10% return earned in 10 years is preferred over a project with an 8% return earned in 3 years
• Another distortion occurs when comparing a single project’s accounting rate of return with the total return for all of the firm’s capital projects
• the decreasing book value of a depreciable investment implies the return on assets increases over the life of the investment

Question 13

What is discounted cash flow analysis?

Answer 13

A more sophisticated method for evaluating potential capital projects than the accounting rate of return. It discounts the relevant flows to present value using the required rate of return as the discount rate.

Question 14

What is the hurdle rate (opportunity cost of capital)?

Answer 14

The minimum acceptable rate when choosing to invest in a project (the required rate of return).

Question 15

What are the considerations in determining the required rate of return (hurdle rate)?

Answer 15

• adjusting for inflation
• adjusting for risk
• division-specific rates of return

Question 16

Why is interest the cornerstone of investment?

Answer 16

Interest represents the price charged by investors (creditors) to permit others to use their money. Investors are willing to forgo the use of money now in exchange for a return at a later moment in time.

Question 17

What is the formula for compound interest and present value/future value?

Answer 17

future value = present value x (1 + interest rate for the period )squared by the number of periods

Question 18

What is present value (PV)?

Answer 18

The present value of a single amount is the value today of some future payment.

Question 19

What is future value?

Answer 19

The future value of a single amount is the amount available at a specified time in the future based on a single investment (deposit) today.

Question 20

What is an annuity?

Answer 20

A series of equal payments at equal intervals of time. Ex - $1,000 at the end of every year for 10 years

Question 21

What is an ordinary annuity (an annuity in arrears)?

Answer 21

A series of payments occurring at the end of each period. The first payment of an ordinary annuity is discounted. Interest is not earned for the first period of an ordinary annuity.

Question 22

What is an annuity due (an annuity in advance)?

Answer 22

A series of payments at the beginning of each period. The first payment of an annuity due is not discounted. Interest is earned on the first payment of an annuity due.

Question 23

What is net present value (NPV) of a capital project?

Answer 23

The present value of all benefits minus the present value of all costs.

Question 24

How do you calculate net present value (NPV)?

Answer 24

net present value = PV of cash inflows - PV of cash outflows

If the NPV is positive the project should be accepted, if the NPV is negative the project should be rejected

Question 25

What are the steps to determine NPV of a capital equipment purchase with a salvage value?

Answer 25

1. determine annual depreciation expense
2. determine annual depreciation tax shield = depreciation exp. x tax rate
3. determine the after-tax inflow from the resale of the machine = proceeds - tax basis of machine - tax expense on proceeds
4. determine the after tax cash savings = cash savings x (1 - tax rate)
5. determine cash flows for each year
6. determine the NPV of the cash flows for each year

Question 26

What is the NPV formula?

Answer 26

NPV = (-1 x initial investment) + (cash flow year 1 / (1 + rate of return)squared by # of year) + (cash flow year 2 / (1 + rate of return)squared by # of year + etc.

Question 27

Lease vs. Buy Decision - how can discounted cash flows analysis be useful in making a decision whether to lease or purchase an asset?

Answer 27

It can help determine the financing option with the lower present value of cash outflows, which is the less expensive option for obtaining the asset.

Question 28

What are the two types of leases for tax purposes?

Answer 28

• operating lease

- finance lease

Question 29

What is an operating lease?

Answer 29

Essentially a regular rental contract in which the ownership of the leased asset is not transferred to the lessee. The entire lease payment can be expensed (deducted) for tax purposes.

Question 30

What is a finance lease?

Answer 30

A finance lease is treated as a purchase of the leased asset by borrowing to finance the transaction. The following can be expensed (deducted) for tax purposes:

• depreciation of the leased asset
• interest expense on finance lease payments

Question 31

What is internal rate of return (IRR)?

Answer 31

The IRR of a project is the discount rate at which the investment’s NPV equals zero. Thus, the IRR equates the present value of the expected cash inflows with the present value of the expected cash outflows.

If the IRR is higher than the hurdle rate - accept the project
If the IRR is lower than the hurdle rate - reject the project

Question 32

What is the formula for IRR?

Answer 32

NPV = initial outlay + year one cash flows / (1 + rate) squared by # of year + year two cash flows / (1 + rate) squared by # of year, etc.

Let NPV = 0 and solve for r

Question 33

How do you calculate the payback period (applicable present value factor)?

Answer 33

payback period = initial investment / after-tax annual revenues

Question 34

What is the payback period?

Answer 34

The payback period is the number of years required for the net cash savings or inflows to equal the original investment. Ex - the time necessary for an investment to pay for itself. It is the breakeven point expressed as time. This method ignores the time value of money

Question 35

What is the advantage of using the payback method?

Answer 35

The advantage of the payback method is its simplicity. The payback period measures the risk and liquidity of an investment, the longer the period, the riskier and less liquid the investment.

Question 36

What are the disadvantages of using the payback method?

Answer 36

• weighting all cash flows equally disregards the time value of money
• all cash inflows after the payback cutoff date are disregarded. Applying a single cutoff date to every project results in potentially accepting marginal projects and rejecting good ones.
• overall profitability is ignored
• it assumes cash flows occur evenly throughout the year

Question 37

What is the discounted payback method?

Answer 37

The discounted payback method considers the time value of money.

Question 38

What is breakeven time?

Answer 38

The time required for the discounted cash flows of an investment to equal its initial cost.

Question 39

What are the disadvantages of the discounted payback method?

Answer 39

• greater complexity

- not considering cash flows after the arbitrary cutoff date

Question 40

What is the profitability index?

Answer 40

The profitability index (or excess present value index) is a method for ranking projects to ensure that limited resources are allocated to the investments with the highest return per dollar invested.

Question 41

What is capital rationing?

Answer 41

Under capital rationing, management determines which investments provide not necessarily the highest total return but the highest per dollar invested. Few firms have the resources to accept every capital project with a return exceeding the hurdle rate. When the initial investment is the same, one can simply choose the independent project with the higher NPV because it will always be the project with the higher profitability index.

Question 42

What is the calculation for profitability index?

Answer 42

profitability index = PV of future net cash flows or NPV of project / initial investment

Question 43

When projects are mutually exclusive (only one project can be accepted for investment), the NPV and IRR methods may rank them differently, for what reasons?

Answer 43

• the cost of one project is greater than the cost of another
• the timing, amounts, and directions of cash flows differ among projects
• the projects have different useful lives
• the cost of capital or desired rate of return varies over the life of the project. The NPV can be determined easily using different desired rates of return for different periods. The IRR determines one rate for the project.
• Multiple investments are involved in a project. NPV amounts are cumulative; IRR rates are not. The IRR for the whole is not the sum of the IRRs for the parts.

Question 44

What is important in choosing between the NPV and IRR methods?

Answer 44

The reinvestment rate

Question 45

How does the NPV method consider the reinvestment rate?

Answer 45

The NPV assumes the cash flows from the investment can be reinvested at the project’s required rate of return. The NPV method provides a better understanding of the problem in many decision situations because reinvestment is assumed to be at the required rate of return.

Question 46

How does the IRR method consider the reinvestment rate?

Answer 46

The IRR method assumes reinvestment is at the IRR. Consequently, the IRR is an accurate representation of a project’s annual return only when (a) the reinvestment is at the actual IRR or (b) the project generates no interim cash flows. Interim cash flows are the cash flows of each year except the first and last years. Thus, if some years have no cash flows, the IRR is less accurate (dependable) than the NPV method.

Question 47

What does it mean if the project’s funds are not reinvested at the IRR?

Answer 47

The ranking calculations obtained may be in error. When a project has an IRR that is close to the reinvestment rate (required rate of return), the annual return is less distorted by the IRR calculation. If the IRR is 10% or more above the reinvestment rate, annual return may be significantly distorted.