B3-FINANCIAL MANAGEMENT-Capital Budgeting Flashcards
Captial Budgeting
Process for evaluating and selecting the long-term investment projects of the firm. Proper capital budgeting is crucial to the success of the organization. The amount of cash the company takes in and pays out for an inventment affects the amount of cash the company has available for operations and other activities of the company.
Capital Budgeting
Cash Flow Effects
Direct Effects
When a company pays out cash, receives cash, or makes a cash commitment that is directly related to the capital investment. It has an imediate effect on the cash available.
Capital Budgeting
Cash Flow Effects
Indirect Effects
Transactions which indirectly are associated with a capital project or which represent noncash activity that produces cash benefits or obligations.
Depreciation is a noncash expense taken as a tax deduction. Depreciation reduces the amount of taxable income and consequently the related taxes. The reduced tax bill resulting from increased depreciation expense associated with a new project decreases the cash paid out. This is an indirect effect (or tax effect).
Captial Budgeting
Stages of Cash Flows
Inception of the Project (time period zero)
Step 1
Today’s cost=initial outflow.
Components
a. Working Capital Requirements=Net CA (CA-CL)
i. Additional working Capital Requirements- “Buy” WC, $ outflow
ii. Reduced WC Requirements- “Sell” WC, $ Increases
b. Disposal of Replaced Assets-offsets cost of new(SP-NBV=Gain or loss.
i. Asset abandonment-net salvage value treated as reduction of the initial investment in the new asset. The abandoned asset’s BV is considered a sunk cost and not relevant to the decision-making process.
ii. Asset Sale- SP (In) - Gain x T (out) + Loss x T (In)= Net proceeds sale of old.
Step 1: Net Initial Cost
Invoice + Ship + Install = Out
+Increase in WC = Out
-Net proceeds sale old=In
Net Outflow
Captial Budgeting
Stages of Cash Flows
Operations
Step 2
Future annual OCF = Inflow
Pretxax CF X (1-T)
Depreciation X T
Captial Budgeting
Stages of Cash Flows
Disposal of the Project
Step 3
One time terminal year CF = Inflow
Step 3:
SP=In
+ Decrease WC = In
-Gain x T= Out
+Loss x T=In
Net Inflow
Final year has two inflows
1. Last OCF
2. TYCF
Capital Budgeting
Calculation of After-Tax CF’s
- Estimate net cash inflows (cash inflows-cash outflows)
- Subtract noncash tax deductible expenses to arrive at taxable income
- compute income taxes related to a project’s income (or loss) for each year of the project’s useful life
- subtract tax expense from net cash inflows to arrive at after-tax cash flows
- alternatively, multiply net cash inflows by (1 -tax rate) and add the tax shield associated with noncash expenses (non cash tax shield such as depreciation multiplied by tax rate). the sum of these two amounts will equal after-tax cash flows.
- the tax savings or expense related to a particlular cash flow equals the amount of the expense or income times the firm’s marginal income tax rate.
Capital Budgeting
Discounted Cash Flow (NPV AND IRR METHODS)
What is it and objective?
DCF valuation methods are techniques that use time value of money concepts to measure the present value of cash inflows and cash outflows expected from a project.
The objective of the DCF method is to focus the attention of management on relevant cash flows appropriately discounted to present value.
Capital Budgeting
Discounted Cash Flow
Limitation?
- Discounted cash flow methods have an important limitation.-they frequently use a simple constant growth (single interest rate) assumption. This assumption is often unrealistic b/c, over time, as management evaluates its alternatives, actual interest rates may fluctuate.
Capital Budgeting
Discounted Cash Flow
Net Present Value Method
What is it? and objective?
One of several discounted cash flow techniques used to screen capital projects for implementation.
The objective of the NPV method is to focus decision makers on the initial investment amount that is required to purchase (or invest in) a captial asset that will yield returns in an amount in excess of a management-designated hurdle rate.
Capital Budgeting
Discounted Cash Flow
Net Present Value Method
Basis of evaluation
NPV requires managers to evaluate the “dollar amount” of return rather than either percentages of return ( as described below for the internal rate of return method) or years to recover principal (as described for the payback methods) as a basis for screening investments.
Capital Budgeting
Discounted Cash Flow
Net Present Value Method
Steps to derive NPV
- Calculate after-tax cash flows=Annual net cash flow x (1 - Tax rate)
- Add depreciation benefit = Depreciation x Tax Rate
- Multiply result by appropriate present value of an annuity
- Subtract initial cash outflow
- Net Present Value
Capital Budgeting
Discounted Cash Flow
Net Present Value Method
Positive vs Negative NPV
Positive Result=Make investment as the rate of return is greater than the hurdle rate
Negative Result=Do not make investment as the rate of return for the project is less than the hurdle rate.
Capital Budgeting
Discounted Cash Flow
Net Present Value Method
Advantage
Net present value analysis may incorporate many types of hurdle rates, such as the cost of capital (the average rate of return demanded by investors), the interest rate of the opportunity cost, or some other minimum required rate of return. All rates are determined by management.
Adjustment to rate-rates may be modified (generally increased) to adjust for:
- Risk
- Inflation-loss of purchasing power
Capital Budgeting
Discounted Cash Flow
Net Present Value Method
Major Advantage of NPV over IRR
Different rates may be used for different time periods using the NPV method. For example, 12 percent might be the rate for the first three years, and 15 percent (which reflects greater risk) might be the rate for subsequent years.
The NVP method of capital investment valuation is considered to be superior to the internal rate of return (IRR) method because it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of return for each year of the project.
