Capital Budgeting Flashcards
Capital Projects on the balance sheet
Long term assets
Capital projects
Projects>1 year
Budgeting
The allocation of funds
Capital budgeting
Funds to long range projects or investments
Real capital investments describe a company better than working capital or capital structure
Working capital and capital structure are intangible
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
Working capital
Current assets - current liabilities
Capital structures
Debt:equity mix for long term financing a companies business
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
An analysts interest in capital budgeting valuation
The capital budgeting focus of maximizing shareholder value
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
Analyzing individual proposals
Gather information to forecast cash flows then evaluate profitability
Planning the capital budget
Must fit with companies strategies and must be timely
Post-auditing and monitoring
Compare actual results to planned or predicted results
Explain differences
Various categories of capital projects
Replacement
Expansion
New products and services
Regulatory
Safety and environmental
Replacement projects
Easy to budget. Just make the replacement to maintain business activities.
Expansion projects
Increasing the size of the business
New products and services projects
Complex. More people and uncertainty.
Regulatory, safety, environmental projects
Imposed by gov. Generate no revenue. Companies undertake to max own interests.
Incremental-after tax cash flows
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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
PI
Profitability Index
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
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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?
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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.
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The capital budgeting process
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Typical capital budgeting steps
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Distinctive categories of capital projects
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Basic principles of capital budgeting
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Basic principles of CF estimation
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Mutually exclusive projects affect the evaluations and selection of capital projects
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Project sequencing
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Project sequencing affects the evaluations and selection of capital projects
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Capitol rationing
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Capital rationing affects the evaluations and selection of capital projects
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Methods to evaluate a single capital project
NPV
IRR
Payback Period
Discounted Payback Period
PI
NPV interpretation
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IRR interpretation
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Payback period interpretation
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Discounted Payback Period interpretation
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PI interpretation
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NPVs role in evaluating independent projects
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IRR’s role in evaluating independent projects
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NPV’s role in evaluating mutually exclusive projects
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IRR’s role in evaluating mutually exclusive projects
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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
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NPV strengths
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NPV weaknesses
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Economic logic behind IRR
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IRR strengths
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IRR weaknesses
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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<Req. Rate of return, reject
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
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
PI
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
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Problems associated with IRR
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NPV profile explained
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Relationship among an investments NPV, Company value, and Share Price
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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
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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
PI
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
