Capital Budgeting I Flashcards
what is payback period
the number of years required to recover a project’s cost ie how long it takes the business to get the money back
is it better to have a shorter or longer payback period
shorter
strengths of payback period
tells us how liquid project is
easy to calculate and understand
weaknesses of payback period
ignores time value of money
ignores cash flows after end of payback period
payback period is arbitrary date
generally is it better to get payments upfront or a stream of payments in the future
now
so you can invest them at the current interest rate
present value formula for cash flow C for a period of n
C / (1+r)^n
what is discounted payback
payback with presesnt values
what is NPV
net present cash flow
sum of PV of all future cashflows - initial cost
accept when NPV
> 0
reject when NPV
< 0
is a higher or lower NPV better
higher
what is a NPV profile
shows NPV at different interest rates on a graph
x axis = rate
y axis = NPV
what is the IRR
internal rate of return
rate when NPV = 0
ie the present value of the future cash flows are equal to the initial cost
how is irr calculated
trial and error
spreadsheet
should you accept if IRR is greater than cost of capital
yes
some return will be left over, ie making more than initial investment
what is the crossover rate
the cost of capital at which the NPV of two projects are equal
why is crossover rate useful in capital budgeting
informs the investing company about a scenario when a currently feasible project will no longer be feasible
how to find the crossover rate
- find cashflow difference between two projects
- treat this as new project
- if it does not go from negative to positive, one project is always better than the other
- otherwise proj x is better before rate and proj y is better after rate
reasons NPV profiles cross
- cashflow size and timing differences (early cashflow better with high cost of capital)
what is a normal cash flow
initial negative cost
followed by a series of positive cash inflows
one change in sign
what is a non normal cash flow
two or more changes in sign
example of when there would be a non normal cash flow
when there is a cost to close a project
what is a weakness of irr
cannot deal with non normal cash flows
can result in multiple irrs
how to overcome problem of multiple irrs
modified irr
how does modified irr work
group cash flows bringing all costs to the start and pushing all cash flows to the end (at discount rate)
FV(inflows) = PV(costs)(1+MIRR)^n
solves for MIRR
what is the profitability index
PV of future cash flows / initial cost
what are some other aspects to take into account when capital budgeting
inflation
tax
working cpital
what is the money/nominal rate of return
real return + inflation
what is the real return
return investor would want if there was no inflation
real and nominal and inflation rates equation
(1+i) = (1+r)(1+h)
i = money discount rate
r = real rate
h = inflation rate
what are nominal cash flows
increased to take inflation into account
`what are the two methods for calculating NPV with inflation
real method = do not inflate cash flows and discount at real rate
nominal method = inflate cash flows and discount at money rate
two give the same NPV
how to calc NPv with specific inflation rates
inflate cash flows at specific rates
discount using money rate
