Capital Budgeting Flashcards
Steps of cost-benefit analysis
- Specify alternative projects
- decide whos beneftis and costs count
- Identify all relevant costs and benefits of the alternative projects
- predict quantitatively (in $) costs and benefits over the life of the project
- Discount benefits and costs to obtain present values
- Compute the net present value (NPV) of each alternative
- Perform sensitiviy analysis
- Make recommendations.
Discount rate/rate of interest/minimum acceptable rate of return (MAR) allows us to…
bridge time in comparing values.
Simple discount rate formula
PV=FV/(1+n)
Real vs Nominal dollars
Nominal dollars are actual price of a good or service.
Real dollars are net of inflation price.
Consumer Price Index CPI
- measures inflation
- calculated by price levels increase or decrease for households
Real price formula
RP= (Nominal price/price index)* Base of price index
Real price calculation e.g Base CPI (of 2011)=100 1980: $35, CPI=26.8 2014: $100, CPI=105.2
1980: 35/26.8*100 =
2014 100/105.2*100=
Real discount rate formula
r=n-p (n= nominal interest rate, p= inflation rate)
PV of a single sum formula
V0=Vn/(1+r)^n
PV of perpetual annuity
V0=a/r
PV of perpetual periodic series
V0=Vt/((1+r)^t -1)
PV e.g: Revenue per t years (Vt)=$100,000/ha Planting Costs(Cp)=$1000/ha Annual management costs (m)=$100/ha/y r=8% t= 40y
Vo=(Vt-Cp/((q+r)^t-1))-(m/r)-Cp
What is a discount rate
opportunity cost of capital (i.e where else could you be putting your money)
NPV
PV of revenues minus PV of costs
NPV decision rule
- result >= 0, project is desirable (NPV of 0 = no return)
- if comparing projects, highest NPV is most desirable
Internal rate of return (IRR)
the discount rate at which the present value of the revenues equals the present value of the costs
- discount rate where NPV = 0
B/C ratio
present value of the benefits divided by present value of the costs
- project is acceptable if B/C = 1 (same as NPV=0)
Payback period
- time it takes to recover invested capital
- shorter period desirable
- disadvanage: doesn’t consider NPV or IRR
Challenges to ranking projects:
- assumption of reinvestment of income earned before end of project at the IRR of the project
- NPV criterion can hide amount of capital required in a project (e.g $1M investment @IRR=6.5 vs $10k inv. @IRR=20% and MAR is ^% then NPV of inv. 1 is higher)
- Unequal investment durations: to compare, put on same time period (i.e 10y project x3 to match 30y project)
