Capital budgeting Flashcards
What does it mean to have a benefit-cost ratio greater than 1?
It means that the present value of benefits is greater than the present value of costs
You have to recommend one alternative from two or more alternatives. If your recommendation has to be based on the benefit-cost ratio, you would select the alternative with:
The highest benefit-cost ratio
One principal reason to finance capital improvement by borrowing instead of paying from resources on hand is
Borrowing helps to distribute costs across generation and future residents
Debt is usually less expensive than giving up equity
Debt can be cheaper than your opportunity cost.
Paying interest on debt reduces tax burden
Governments use debt financing to
Cover deficits of annual expenditures
State and local governments use many different debt instruments because:
They sometimes seek to evade statutory or constitutional debt limits
Revenue bonds are backed by the
The specific revenues generated by the project being financed
What is capital budgeting?1
Capital budgeting is the process by which capital budgets become planning and policy instruments used by states and local governments in guiding investment in long-life fixed assets
What is capital budgeting?
the process used to evaluate and determine potential expenses or investments in large projects such as:
1) building a new plant
2) investing in a long-term venture
3) buying another company
What is the payback period approach?
length of time required to recover the cost of an investment
What are two advantages of used the payback period?
1) useful in evaluating project liquidity
2) short payback period reduces uncertainty
What are two disadvantages of using the payback period?
1) ignores TVM
2) does not measure total project profitability
How do you calculate the payback period?
years = initial investment / ANNUAL after-tax net cash flow (or savings)
How do you calculate the ANNUAL after-tax net cash flow?
CF - cash expenses + non-cash expenses
How does depreciation affect ANNUAL after-tax net cash flow?
its ignored (i.e. added back) to the extent depreciation expense is tax deductible which is called a tax shield
How do you calculate the tax shield for depreciation?
tax shield is ADDED back to ANNUAL after-tax net cash flow
= depreciation expense x tax rate %
Does the residual value affect considered in the payback period approach?
no, its ignored
What is the internal rate of return (IRR) approach and why is it used?
1) discount rate at which an investments NPV of all cash flows equals zero
2) to evaluate the attractiveness of a project or investment
What is the advantages of using the IRR?
takes into account a projects total profitability by discounting all projected CF using the hurdle interest rate
What are three disadvantages of using the IRR?
) requires estimation of CF over the entire life of project, which could be very long
2) requires all CF be either inflows or outflows
3) assumes CF from the project are immediately reinvested at the project’s IRR
What is the IRR compared to in order to determine if a project should be accepted or not?
hurdle rate
What is the hurdle rate?
the lowest acceptable rate of return on investment (aka the cost of capital)
What is the accounting rate of return approach? (ARR)
measures expected annual accounting income from a project as a percentage of the initial (or average) investment
What is the net present value approach? (NPV)
difference between PV of cash inflows and PV of cash outflows (typically the investment made today)
What are two advantages of using the NPV?
1) relates project rate of return to cost of capital
2) considers the entire life and results of project
What are two disadvantages of using the NPV?
1) requires estimation of CF over entire life of the project, which could be very long
2) assumes cash flows are immediately reinvested at the discount rate
How do you calculate the NPV?
PV of future cash inflows - initial investment (or PV or future cash outflows)
used to rank projects because it allows you to quantify the amount of value created per unit of investment
profitability index (PI)
How do you calculate the PI when using the PV of future cash flows?
PV of cash inflows/project cost
How do you calculate the PI when using the NPV?
NPV / project cost
the discount rate refers to the
interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows.
What effect does a higher discount rate on the time value of money?
Future cash flows are discounted at the discount rate, and so the higher the discount rate the lower the present value of the future cash flows. Similarly, a lower discount rate leads to a higher present value.
the discount rate is higher
money in the future will be “worth less”, or have lower purchasing power, than dollars do today.
How do you choose the appropriate discount rate?
- Use the opportunity cost
- Use its weighted average cost of capital (WACC)
- used the historical average returns of an asset or project similar to the one being analyzed
Use the opportunity cost
Individuals should use the opportunity cost of putting their money to work elsewhere as an appropriate discount rate - simply put, it’s the rate of return the investor could earn in the marketplace on an investment of comparable size and risk
Cost of capital
is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. When analysts and investors discuss the cost of capital, they typically mean the weighted average of a firm’s cost of debt and cost of equity blended together.
weighted average cost of capital (WACC).
Many companies use a combination of debt and equity to finance their businesses and, for such companies, the overall cost of capital is derived from the weighted average cost of all capital sources, widely known as the weighted average cost of capital (WACC).
Earning Potential
Earning potential refers to the potential gains from dividend payments and capital appreciation shareholders might earn from holding a stock. In other words, it reflects the largest possible profit that a corporation can make. It is often passed on to investors in the form of dividends.
earnings per share (EPS), return on assets (ROA) or return on equity (ROE) basis.
Discounted Cash Flow (DCF)
Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future.
Cash Flow
Cash flows are the net amount of cash and cash-equivalents being transferred into and out of a business. Cash received are inflows, and money spent are outflows.
FCF
Free cash flow is the cash that a company generates from its normal business operations after subtracting any money spent on capital expenditures.
