3. Capital Budgeting Flashcards
What is the definition of capital budgeting?
The process of measuring, evaluating and selecting long-term investment opportunities for a firm.
What are examples of investment?
- Selecting new equipment/plants
- Evaluating new products
- Making advertising campaign decisions
- Similar undertakings
What are 2 elements of capital undertakings?
Risk and reward.
What is risk?
The possibility of loss or other unfavorable results that derives from uncertainty implicit in future outcomes.
What are capital project risks?
- Incomplete or incorrect project analysis
- Unanticipated actions of customers, suppliers and competitors
- Unanticipated changes in laws and regulations
- Unanticipated macroeconomic changes, including interest rates, inflation rates, tax rates, etc
What is reward?
The benefit expected or required from investment of resources in capital projects and other undertakings.
What is the relationship between risk and reward?
The greater the perceived risk, the greater the expected reward.
What does a graph look like for risk/reward relationship?
Y-axis=expected reward. X-axis=perceived risk.
- Risk return relationship = Straight line up to the right, starting from not (0,0).
- Risk free rate = a vertical line, starting from the starting point of risk return relationship line.
- Risk free return = the area beneath the risk free rate line.
- Risk premium = the area between risk return relationship line and risk free rate line.
What does risk return relationship consist of?
Risk free return + Risk premium
What does cost of capital determine?
Rate of return the firm must earn on the project.
What are 6 techniques for evaluation and selection of capital projects?
- Payback period approach
- Discounted payback period approach
- Accounting rate of return approach
- Net PV approach
- Internal rate of return approach
- Profitability index approach
What is payback period approach?
Determines the number of years needed to recover the initial cash investment in a project and compares that time with a pre-established maximum payback period.
Payback period approach: What is the result and interpretations?
*If payback period
Payback period approach (PPA): ex:
Proposed project = $250,000, no residual value.
Expected cash inflows:
yr 1 = 50,000, 2-4=75,000, 5=25,000 (total 300,000).
Maximum payback period=3 yrs.
Payback period = 50,000 + 75,000 + 75,000 = 200,000 which is less than the cost of project 250,000.
Therefore, reject the project.
Payback period approach: Advantages?
- Easy to use and understand
- Useful in evaluating project liquidity
- Establishing a short maximum period reduces uncertainty
Payback period approach: Disadvantages?
- Ignores time value of money (uses nominal values)
- Ignores cash flows after payback period
- Does not measure total project profitability
- Maximum payback period established may be arbitrary
How to use sum-of-the years digit? 5 year life?
(life of item / 5+4+3+2+1) / cost - salvage value
How to compute payback period?
Divide the initial cost of the project by the undiscounted estimated annual net cash inflows.
Payback = net investment cost (cost - cash expense) /annual cash savings.
Discounted Payback Period Approach: what is it?
Determines the number of years needed to recover the initial cash investment in a project using discounted cash flows and compares that time with a reestablished maximum payback period.
Discounted Payback Period Approach: how to interpret the result?
If payback period maximum period - reject
Discounted Payback period approach: ex:
Proposed project = $250,000, no residual value.
Expected cash inflows:
yr 1 = 50,000 (6% PV factor: .943), 2 (.890)=75,000, 3 (.840)=75,000, 4 (.792)=75,000, 5 (.747)=25,000 (total 300,000).
Maximum payback period=3 yrs.
PV amount; 1 = 50,000 x .943 = 47,150 2 = 66,750 3 = 63,000 4 = 59,400 5 = 18,675 3 yr payback = $176,900 < 250,000 cost. Therefore, reject project
Discounted Payback Period Approach: Advantages?
- Easy to use and understand
- Useful in evaluating project liquidity
- Establishing a short maximum period reduces uncertainty
- Uses time value of money concept
Discounted Payback Period Approach: Disadvantages?
- Ignores cash flows after payback period
- Does not measure total project profitability
- Maximum payback period established may be arbitrary
Discounted Payback Period Approach: Do you consider salvage value?
No
Accounting Rate of Return Approach (ARR): What is it?
Determines the expected annual incremental accounting net income from a project as a percent of the initial (or average) investment.
Accounting Rate of Return Approach: Formula?
(Average annual incremental revenue - Average annual incremental expenses = Average net incremental income=AFTER TAX VALUE) / Initial (or average) investment
Accounting Rate of Return Approach: ex:
Proposed project = $250,000, no residual value.
Expected INCREMENTAL NET INCOME:
yr 1 = 12,000, 2=18,000, 3=26,000, 4=24,000, 5=20,000 (total 100,000/5 yrs = $20,000 average).
ARR = $20,000/250,000=0.8=8%ARR
If ARR >or= Pre-Established rate = accept
If ARR < Pre-established rate = reject
Accounting Rate of Return Approach: Advantages
- Easy to use and understand
- Consistent with FS values
- Considers entire life and results of project
Accounting Rate of Return Approach: Disadvantages?
- Ignores time value of money
* Uses accrual accounting values, not cash flows
Accounting Rate of Return Approach: Considers depreciation?
Yes because it is incremental ACCOUNTING expense
Accounting Rate of Return Approach: What is the average cost of investment when there is salvage value?
(Cost + salvage value) / 2
Net Present Value Approach: What is it?
Determines the PV of expected cash inflows and compares that value with the PV of expected outflows in the project.
Net PV Approach: How is PV determined?
Using discount rate, also called “hurdle rate”, based on cost of capital to firm (e.g. WACC).
Net PV Approach: What is net PV and interpretation?
Difference between PV of cash inflows and outflows (initial cash investment).
If NPV >or 0 = Accept
If NPV < 0 = Reject
Net PV Approach: Ex:
Proposed project: Initial cash outlay = $250,000, no residual value, 6% discount rate.
Expected cash inflows:
yr 1 = 50,000 (6% PV factor: .943), 2 (.890)=75,000, 3 (.840)=75,000, 4 (.792)=75,000, 5 (.747)=25,000.
PV: 1 = 50,000 x .943 = 47,150. 2 = 66,750 3 = 63,000 4 = 59,400 5 = 18,675 Total PV = $254,975 Net PV = 254,975 - Cost 250,000 = $4,975 > 0. Therefore, accept.
Net PV Approach: Advantages?
- Recognize time value of money
- Relates project rate of return to cost of capital
- Consider entire life and results of project
- Easier to compute than Internal Rate of Return (IRR)
Net PV Approach: Disadvantages?
- Requires the estimation of cash flows over the entire life of project which could be very long
- Assumes cash flows are immediately invested at the discount (hurdle) rate of return used
Net PV Approach: how is residual value treated?
As a part of inflow.
Net PV Approach: How is depreciation treated?
The amount of depreciation expense taken reduces taxes due, it reduces cash outflow by the amount of taxes saved.
Otherwise, because PV is based on cash flows, depreciation is not considered.
Internal Rate of Return (IRR) Approach: What is it?
Determines the discount rate that equals the PV of expected cash inflows with the PV of expected cash outflows.
The discount rate = The rate of return on the project.
IRR Approach: How does it compute the discount rate?
Discount rate that makes NPV of cash flows equal to 0.
IRR Approach: Formula?
Equation for NPV = 0;
Future annual cash inflows x PV factor = Investment cost
PV factor = Investment cost / Future annual cash inflows
IRR Approach: Ex:
Proposed project: Initial cash outlay = $37,500, no residual value.
Expected cash inflow = $10,000 per year for 5 yrs.
PV factor = 37,500 / 10,000 = 3.750
Look at the PV factor table for 5 periods;
3.750 falls between 3.605 (Discount rate: 12%) and 3.791 (10%).
IRR Approach: Advantages?
- Recognize time value of money
* Considers entire life ad results of the project
IRR Approach: Disadvantages?
- Difficult to compute without a financial calculator; even more difficult when cash flows are uneven
- Requires estimation of cash flows over entire life of project, which could be very long, and that all cash flows be either positive or negative.
- Assumes cash flows are immediately reinvested at internal rate of return
NPV vs IRR approaches
- NPV: Uses a rate of return (hurdle rate) to determine whether or not the PV of net cash flow is positive = If so, the project will earn at least the hurdle rate.
- IRR: Determines what rate of return makes the net PV of net cash flows equal to 0 = That rate of return is the rate earned by the project.
NPV vs IRR approaches: The internal rate of return would be greater, equal, or less than hurdle rate if NPV is positive?
Greater.
Project Ranking: what is the approach used?
Profitability Index (PI) Approach. PI is also called Cost-Benefit-Ratio.
Profitability Index Approach: What is it?
Determines project rankings by taking into account both the net PV and the cost of each project.
Profitability Index Approach: PI calculation? How is the result interpreted?
PI = NPV of project inflows / PV of project cost
Higher the percentage = Higher the rank
Profitability Index Approach: Ex:
Proposed project:
Project A: NPV = $60,000/cost $50,000=1.2
Project B: 110,000/100,000 = 1.10
Project A ranks higher than B.
Profitability Index Approach: What is the lowest acceptable measure of PI when using NPV or NPV of cash inflows?
NPV: 0.0.
NPV of cash inflows: 1.0
What is the firms’ need to allocate limited resources to the most beneficial projects called?
Capital rationing.
How does Payback Period Approach determine ranking?
Ranks projects based on how quickly invested capital is recovered.
- It uses nominal dollars, not discounted values
- It does not rank in terms of relative total economic value, it only considered outcome up to point at which initial investment is recovered
- Useful for ranking when liquidity is a major concern
How does Discounted Payback Period Approach determine ranking?
Ranks projects based on how quickly invested capital is recovered using discounted cash flows.
- Better than the undercounted payback period approach
- It does not rank in terms of relative total economic value, it only considered outcome up to point at which initial investment is recovered
- Useful for ranking when liquidity is a major concern
How does Accounting Rate of Return Approach determine ranking?
Ranks projects based on annual incremental accrual-based net income as a percentage of initial investment
- Higher percent = Higher ranking
- Ignores the time value of money
- Uses accrual accounting values, not cash flows
How does NPV Approach determine ranking?
Ranks projects based on their relative net PV.
*Higher net PV = Higher ranking
*Recognizes the time value of money = ranking in terms of comparable dollars
*Projects with negative net PV = not considered
*Fails to consider differences in initial project costs
= A preferred method
How does Internal Rate of Return Approach determine ranking?
Ranks projects based on their relative internal rate of return.
- Higher IRR = Higher ranking
- Recognizes the time value of money
- Fails to consider differences in initial project costs
Does IRR and NPV approach always result in the same ranking?
No because of the differences in;
Project investment cost
Timing of cash flows
Project life-span
How does Profitability Index Approach determine ranking?
Ranks projects based on the NPV of each project as a percentage of initial investment costs of each.
- Higher PI index = Higher ranking
- Recognizes time value of money
- Takes into account the cost of each project
What is coefficient of variation and the formula to compute?
The coefficient of variation provides a measure of the relative variability of investments.
The standard deviation of the investment / its expected return.
