5,6. Capital Budgeting Flashcards
Strengths of NPV
- Clear decision rule that maximises shareholder wealth.
- Incorporates time value of money.
- The technique defines relevant cash flows
- Incorporates risk of the project.
- Considers all cash flows expected to be generated by a project; i.e. uses all available information.
- Correctly ranks projects on wealth maximising criterion.
Weaknesses of NPV
- There is a difficulty in forecasting future cash flows.
- There are problems in estimating the appropriate discount rate.
- It is difficult for non-finance trained mangers to fully understand what it means.
Strengths of IRR
- Provides a clear decision rule that targets a hurdle rate acceptable to shareholders.
- Is easily comparable to rates of return on other investments.
- Incorporates the time value of money.
- Incorporates the cost of the project as well as its cash flows.
- Management feel they can understand the concept.
Weaknesses of IRR
- Calculation is mathematically problematic without a computer or financial calculator.
- Decision rule requires us to know whether it is a financing or investment project.
- If there are positive and negative cash flows there may be multiple solutions.
- Does not take into consideration the scale of the project.
Strengths of Payback method
- Simple to estimate.
- Provides a clear decision rule – accept the project with shortest payback period.
- Ranks projects on the basis of time taken to recover costs – therefore simple to interpret.
Weaknesses of payback method
- What is the appropriate payback period for a particular project/company? An arbitrary cut-off period must be selected by management.
- Ignores cash flows that occur after the cut-off period. ((ie if project B takes 3 years but after 3rd year you have $100 it would be a really good project, however this approach doesn’t indicate this)
- Ignores time value of money.
- Gives = weight to all cash flows before the cutoff date
Strengths of (Average) Accounting Rate of Return
- Uses reported accounting numbers.
* There is no clearly defined decision rule.
Weaknesses of (Average) Accounting Rate of Return
- Uses reported accounting numbers.
- There is no clearly defined decision rule. • Ignores the time value of money.
- Cannot discriminate between projects.
- Requires arbitrary selection of target ARR.
- Does not maximise shareholder wealth.
when calculating NPV what must be included in the cash flows?
Use cashflows not accounting income (ie Just copy the operating cash flows (EBDIT) then adjust for investment costs, ie at year 0, project costs $3m (cash outflow), then tax)
Include opportunity costs (If project uses resources which could be put to some other use, then $ value of alternative use must be included as cash outflow)
Include side effects (i Include positive or negative cashflows which result to other aspects of the business as a result of taking on the current business)
Include working capital (Funds set aside to ensure that the company has sufficient cash flows to maintain operations whilst undertaking the project (how current liabilities are utilised in the current assets)
Do we account for depreciation in the cash flows for Npv?
no
net working capital
Net working capital = Current Assets – Current Liabilities
why do we use CFs not accounting income in capital budgeting??
Cash flow generated by a project is not the same as accounting income.
We want “free cash flow” –> total CF - capital expenditure.
Calculation of accounting income incl. depreciation, which is a non-CF accounting item that reduces the apparent CF of the project.
This is a significantly different number to free cash flow, as accounting seeks to spread income across time and does not take into account the time value of money. Cash flow analysis charges the cost of the asset at the time it is purchased (usually to) as a cash outflow.
why do we include OCs in capital budgeting??
Opportunity costs are included in the analysis as CFs.
If a corporation uses a resource in a project which would otherwise be available for an alternative use, then the dollar value of that lost cash inflow is treated as an outflow for the project under consideration.
why do we include side effects in capital budgeting?
because they impact upon the value of existing business. In keeping with the principle of including all cash flows that arise as a result of implementing the project, side effects are included.
what are sunk costs?
Sunk costs are cash flows which have been incurred already as a result of evaluating a project and that would have been (or will be) incurred whether the project proceeds or not.
Inclusion of sunk costs may result in firms incorrectly accepting or rejecting projects.
why are interest expenses and loan repayments excluded from the free CF calculation?
We wish to know if the project is value increasing before we determine how we are to finance it. That is, we wish to know if the project achieves the market rate of return for a given level of risk.
is opportunity cost included in taxable income?
yes
