Capital Budgeting Flashcards
What are some principles of capital budgeting?
- Relevancy
- Time zero
- Cash flows
- Finding number of years for the analysis
- Last year of project
- Tax considerations
What is the principle of relevancy in capital budgeting?
- It’s usually long term, therefore time value of money needs to be taken into account
- Take into consideration before project and after accepting project
- If difference can not be quantified, it is included in additional factors
What is the principle time zero in capital budgeting?
- The initial investment usually occurs at time zero, therefore accounted for as initial outflow in year zero
- When selling old asset in time zero, it is accounted for as inflow
- Changes in working capital should be taken into account in time zero to ensure enough working capital is available for the years ahead.
Working capital requirement = inventory + debtors - creditors
What is the principle of cash flow in capital budgeting?
- Only cash flows will be taken into account in a capital budget
- After tax net profit needs to be adjusted by adding or subtracting non cash items previous added or subtract in the income statement.
What is the principle of number of years for the analysis in a capital budget?
- Analysis must be done for the period of useful life of the asset to be purchased
What is the principle of last year of project in a capital budget?
- Proceed from sale of asset bought (salvage value) = inflow
- Changes in net working capital added in the beginning of the project(time zero) must be reversed.
What is the principle of tax in capital budgeting?
- Separate calculation
- Important sections are:
- section 12C manufacturing plant or equipment
40% 20% 20% 20% (no apportionment) - section 11(e) wear and tear allowance
As per table - section 8(4)(a) recoupment
Selling price - tax value x tax rate - section 8(o) scrapping allowance
Tax value - selling price x tax value - capital gains tax (50% inclusion rate)
Proceed - base cost = capital gain
Proceed = selling price - recoupment
- section 12C manufacturing plant or equipment
What is capital budgeting?
The analysis and evaluation of investment projects that normally produce benefit over a number of years.
List the factors as to why proper evaluation of investment project are critical.
- Over investment in capital project may result in higher costs
- Under investment in capital project may result in the firm losing market share
List the types of investment projects.
- Replacement or expansion
- Independent or mutually exclusive
- Divisible or indivisible
Name some of the capital budgeting techniques.
- Net present value (NPV)
- Internal rate of return (IRR)
- Payback method
- Accounting rate of return (ARR)
- Discount payback method
- The profitability index (PI)
- Modified internal rate of return (MIRR)
- Economic value added (EVA) or economic profit
What does net present value involve?
It involves estimating a project’s future cash flows, discounting these cash flows at the company’s required rate of return (cost of capital) and subtracting the cost of investment from the present value.
If the NPV is positive then accept the project. This indicates that the project results in an increase in the value of the firm as the project more than earns the required rate of return.
What is the internal rate of return?
It’s the discount rate that causes the present value of net future cash flows to equal to the cost of investment. It reflects the implicit return of the project stated in percentage terms.
To decided whether or not to accept a project, IRR should be compared to cost of capital. If IRR is higher than cost of capital then accept the project. As it offers a higher return than the cost of financing the project.
What is the payback method?
It measures the time it takes for a firm to recover the cost of investment from cash flows generated by the project.
It can be used as a crude indicator of risk, as it indicates how long the funds are at risk.
When a project will earn equal cash flows every year (annuity) the payback period can be found by dividing the cost of investment by the annual cash flow.
What are some disadvantages with the payback method?
It ignores cash flows after the payback period, therefore not a profitability indicator and it creates bias against long term investments.
It ignores time value of money.
What is the accounting rate of return?
ARR = average incremental net income / average investment
It also ignores time value of money.
What is the discount payback method?
The time it will take for the present value of a project’s cash flow to equal to the cost of investment.
What is the profitability index?
It measures a project’s return in relation to its cost.
Also known as the benefit cost ratio.
It is the present value of future cash flows divided by the present value of the cost of the project. If PI is higher than 1 = accept.
What is the modified internal rate of return?
It assume a reinvestment rate equal to the cost of capital until the end of project, it is determined by calculating the rate that causes PV of the terminal value of a project to equal to the PV of project’s future cash flows.
What is the economic value added (EVA) or economic profit?
Economic profit = net profit after tax - (invested capital x WACC)
Economic profit = net profit after tax - (opening book value x WACC)
EVA = (return on capital - WACC) x invested capital
Value = investment + PV of future EVA’s
PV of future EVA’s = NPV
List the four main categories of cash flows.
- Beginning of project cash flows
- Annual operating cash flows
- Tax
- End of project cash flows
What are some rules of cash flow determination?
- Use only incremental cash flows
- Use after-tax cash flows
- Ignore sunk costs
- Evaluate all alternatives
- Ignore finance charges
- Include incremental investment in working capital
- Separate financing decision from investing decision
- Taxation
What is a post audit?
It compares results with estimated cash flows used in capital budget and provides explanation for the difference so is to improve the capital budgeting process and to improve management of project subsequent to implementation.
What are some advantage and disadvantages of post audit?
Advantage: lesson for management to identify critical factors and ensure focus on achieving projected cash flows
Disadvantages:
- sponsor may reduce investment due to personal risk
- difficulties in separation of project cash flows from other business investments
