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.
Capital Budgeting
Discounted Cash Flow
Net Present Value Method
Limitation
Although considered the best single technique for capital budgeting, teh net present value method of capital budgeting is limited by not providing the true rate of return on the invesment. It purely indicates if the NPV will earn the hurdle rate used in the NPV calculation.
Capital Budgeting
Discounted Cash Flow
Net Present Value Method
Profitability Index
is the ratio of the present value of net future cash inflows to the present value of the net initial investment. aka the excess PV index or simply the present value index. Ranking and selection of investment alternatives anticipate positive net present values for all successfully screened investments. Measures cash flow return per dollar invested; the higher the more desirable the project.
Profitability Index = PV of Net Future Cash Flows
PV of Net Initial Investment
Capital Budgeting
Discounted Cash Flow
Interal Rate of Return
What is it?
“It is the single rate that will set the PVFCF=Today’s cost-zero NPV”
One of several discounted cash flow methods used to screen the acceptability of investments. aka as the expected rate of return of a project. The IRR method determines the present value factor (and related interest rate) that yields an NPV equal to zero. (The present value of the after-tax net cash flows equals teh initial investment on the project).
Focuses the decision maker on the discount rate at which the present value of the cash inflows equals the PV of teh cash outflows.
Capital Budgeting
Discounted Cash Flow
Interal Rate of Return
Limitations
- Unreasonable reinvestment assumption-cash flows from the investment are assumed in the IRR analysis to be reinvested at the internal rate of return. If internal rates of return are unrealistically high or low, assumed returns on reinvested cah flows based on IRR rates could lead to inappropriate conclusions.
- Inflexible Cash Flow assumptions-Timing or amount of CFs used to determine IRR can be misleading when compared to NVP method. The IRR method is less reliable than the NVP method when there are several alternating periods of net cash inflows and net cash outflows or the amounts of the CFs differ significantly.
- Evaluates Alternatives Based Entirely on Interest Rates-Evaluates investment alternatives based on achieved IRR and does not consider the amount of profit. “Does not tell you the dollar value added like NPV.”
Capital Budgeting
Discounted Cash Flow
Payback Period Method
What is it?
Time required for the net-after tax cash inflows to recover the initial investment in a project.
Objective is to focus decision makers on both liquidity and risk.
Liquidity-measures the time it will take to recover the initial investment in the project, thereby emphasing the project’s liquidity and the time during which return of principal is at risk.
Risk-longer time increased Risk.
Capital Budgeting
Discounted Cash Flow
Payback Period Method
Calculation
Payback period = Net Initial Investment
Increase in annual net after-tax cash flow
Capital Budgeting
Discounted Cash Flow
Payback Period Method
Advantages and Limitations
Advantages:
- Easy to use and understand
- Emphasis on liquidity-focuses management on return of principal.
Limitations:
- The time value of money is ignored-see discounted payback
- Project cash flows occurring after the initial investment is recovered are not considered
- Reinvestment of CFs is not considered
- Total project profitability is neglected
Capital Budgeting
Discounted Cash Flow
Discounted Payback Method
What is it and the objectives?
What is it?
This variation computes the payback period using expected cash flows that are discounted by the project’s cost of capital (the method considers the time value of money). Aka the breakeven time method (BET).
Objectives
- Focus on liquidity and profit-“some but not all profit”-focuses decision makers on the number of years needed to recover the investment from discounted net cash flows. Profit is built into cash flows using the discount rate.
- Evaluation Term-computation begins when the project team is formed and ends when the initial investmetn has been recovered.
- Common Projects using Discounted Payback-used to evaluate new product development projects of companies that experience rapid technological changes. These companies want to recoup their investment quickly, before their products become obsolete.
Capital Budgeting
Discounted Cash Flow
Discounted Payback Method
Advantages and Limitations
- Same as payback method with the exception that the discounted payback method takes into account the time value of money. Both focus on how quickly the investment is recouped rather than overall profitability of the entire project.
Calculating Time Value of Money without Factors
Present Value of $1
PV = FV / (1 + r)n
Calculating Time Value of Money without Factors
Present Value of Annuity
PV = PMT x 1 - 1
(1+r)n <span>/</span><span>r</span>
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