Capital Budgeting Flashcards by Steven Popovic

Capital Projects on the balance sheet

Long term assets

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Capital projects

Projects>1 year

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Budgeting

The allocation of funds

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Capital budgeting

Funds to long range projects or investments

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Real capital investments describe a company better than working capital or capital structure

Working capital and capital structure are intangible

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Working capital and capital structure tend to be similar for many corporations

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Capital budget decision making is important

They’re long term so mistakes are costly.

The principles of capital budgeting apply to investments in working capital, leasing, mergers and acquisitions, bond refunding

Capital budgeting valuation principles are similar to security analysis principles and portfolio management principles

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Working capital

Current assets - current liabilities

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Capital structures

Debt:equity mix for long term financing a companies business

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Leasing

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Mergers and acquisitions

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Bond refunding

???

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Capital budgeting principles or assumptions

Decisions are based on CF’s, not NI

Intangibles are ignored

Timing of CF’s is crucial

CF’s are based on opportunity costs

CF’s are analyzed on an after tax basis

Financing costs are ignored

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An analysts interest in capital budgeting valuation

The capital budgeting focus of maximizing shareholder value

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The cash flows that go into the capital budgeting model

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Extensions of the basic capital budgeting model

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The most critical investments for many corporations

Investments in long-term assets

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Analyzing individual proposals

Gather information to forecast cash flows then evaluate profitability

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Planning the capital budget

Must fit with companies strategies and must be timely

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Post-auditing and monitoring

Compare actual results to planned or predicted results

Explain differences

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Various categories of capital projects

Replacement

Expansion

New products and services

Regulatory

Safety and environmental

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Replacement projects

Easy to budget. Just make the replacement to maintain business activities.

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Expansion projects

Increasing the size of the business

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New products and services projects

Complex. More people and uncertainty.

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Regulatory, safety, environmental projects

Imposed by gov. Generate no revenue. Companies undertake to max own interests.

Incremental-after tax cash flows

???

Capital budgeting decision base

NPV The PV of all after tax CF's

Capital budgeting decision process ignores financing costs

The discount rate already captures the cost of debt and the cost of other capital

Net present value

Present value of all after-tax cash flows

r in NPV

The investments required rate of return

Investment outlays in NPV

Negative CF's

IRR

Sums PV of all future CF's to 0

Payback period

Periods till CF's payback the investment

Discounted payback period

Periods til cumulative discounted CF's payback the initial outlay (investment)

AAR

Average Accounting Rate of Return

Average accounting rate of return

Avg NI / Avg Book Value Avg profit per resources basically?

Book value

Net excess amount of total assets or total liabilities

Profitability Index

The PV of a projects future CF's / initial investment

PI will =

1+NPV/initial investment

Capital budgeting decision rule - invest

NPV>0 , IRR > r , PI > 1.0

NPV>0

Invest

IRR>r

Invest

PI>1.0

Invest

No decision rules for the payback period, discounted payback period, AAR

Not always sound measures

payback period, discounted payback period, AAR are not always sound measures

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NPV profile

NPV graphed as a function of various discount rates

Mutually exclusive projects that are ranked differently by NPV and IRR

???

If mutually exclusive projects are ranked differently by NPV and IRR, then be economically sound

Choose The project with the higher NPV

Multiple IRR problem

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No IRR Problem

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Nonconventional cash flows

CF's that change signs more than once during a projects life

Projects with non-conventional cash flows cause this...

Multiple IRR problem or No IRR problem

Why do non-conventional cash flows occur?

The popularity of NPV as an evaluation method

Projects with a positive NPV theoretically increase the value of a company and it's stock.

Evaluation method.

The capital budgeting process

Typical capital budgeting steps

Distinctive categories of capital projects

Basic principles of capital budgeting

Basic principles of CF estimation

Mutually exclusive projects affect the evaluations and selection of capital projects

Project sequencing

Project sequencing affects the evaluations and selection of capital projects

Capitol rationing

Capital rationing affects the evaluations and selection of capital projects

Methods to evaluate a single capital project

NPV IRR Payback Period Discounted Payback Period PI

NPV interpretation

IRR interpretation

Payback period interpretation

Discounted Payback Period interpretation

PI interpretation

NPVs role in evaluating independent projects

IRR's role in evaluating independent projects

NPV's role in evaluating mutually exclusive projects

IRR's role in evaluating mutually exclusive projects

Other projects

Pet or RD

Economic income

Economic income does not subtract the cost of debt financing Econ income is based on changes in the market value of the company - not book value

Required rate of return or opportunity cost of funds or cost of capital

Required discount rate given a projects riskiness

Important capital budgeting concepts that managers find useful

Sunk cost Opportunity cost Incremental cash flow Externality Conventional CF's v. Nonconventional CF's

Sunk cost

Costs already incurred which cannot be changed. Sunk costs do not effect current and future CF's

Opportunity cost

What a resource is worth in its next best use

Incremental cash flow

The CF that is realized because of a decision

Externality

A positive or cannibalistic effect of the project on CF's of other parts of the company.

Conventional CF pattern

Initial outflow is followed by a series of inflows

Nonconventional CF pattern

The initial CF is not followed by inflows only but also changes to the signs, + - + - If CF's change signs two or more times

Project interactions that make incremental CF analysis challenging

Independent projects v. Mutually exclusive projects Project sequencing Unlimited funds v Capitol rationing

Independent projects

CF's are independent of each other

Mutually exclusive projects

Projects compete directly with each other and only one can be chosen

Project sequencing

Investing through projects in time especially if CF's one project could budget a second project.

Unlimited funds

A company can raise a project simply by paying the required rate of return

Capital rationing

Company's should ration capital especially when they have more profitable projects than funds in order to achieve max shareholder value.

Economic logic behind NPV

NPV strengths

NPV weaknesses

Economic logic behind IRR

IRR strengths

IRR weaknesses

Independent projects decision rule

Accept any projects that increases shareholders wealth aka NPV > 1

IRR definition

For a project with one investment outlay, made initially, the IRR is the discount rate that makes the PV of the future after-tax CF's equal to the investment outlay.

IRR Decision Rule

Determine the required rate of return for a project If IRR > required rate of return accept IRR

The required rate of return for a project

Is usually the firms cost of capital

The payback period

The number of years it takes to recover the cost of the initial investment

The payback period is measure of liquidity that means

A shorter payback period is better, especially for firms with liquidity concerns

Main payback period drawbacks

PBP don't account the TVM or CF's beyond PBP

Terminal or salvage value isn't considered, useless as a measure of profitability

PBP main benefit

Good measure of project liquidity

PBP when annual CF's are =

Project cost\annual CF

Discounted payback period

A liquidity measure, not profitability The number of years it takes a project to recover its initial investment in present value terms

PI, NPV, IRR relationship

If PI>1 then NPV>0 and IRR>r, etc

The PV of a projects future CF's \ initial cash outlay

Another IRR def when outlays occur t=0 or future dates

The discount rate that makes the PV of all CF's sum to 0

Problems associated with NPV

Problems associated with IRR

NPV profile explained

Relationship among an investments NPV, Company value, and Share Price

What is payback based on?

CF's

PBP advantage

Very easy to calculate and to explain

PBP has no decision rules

It isn't economically sound

Economically sound

A project with negative NPV does not have a discounted payback period

Since -NPV indicates that the CF is not paid back

How DPBP corrects PBP

Accounts for TVM and risk within discounted payback period.

DPBP and PBP ignore CF's after DPB or PB is reached

It's possible a project has negative NPV but to have a +cumulative DCF in the middle of its life and this a reasonable discounted payback period

AAR

Avg NI/ Avg book value

AAR advantages

Easy to understand easy to calculate

AAR disadvantages

Based on accounting numbers not CF's Doesn't account TVM Doesn't distinguish what's profitable or unprofitable Callcd many different ways

PV projects future CF/ initial investment(outlay)

PI v NPV regarding future CF and initial outlay

PI is the ratio NPV is the difference

PI indicates the value you are receiving in exchange for one unit of currency

Or benefit-to-cost ratio