Capital Budgeting (W2-4) Flashcards
NPV Minimum Acceptance Criteria
Accept if NPV > 0
NPV Ranking Criteria
Choose highest NPV
Why use NPV? (2)
Uses all the cash flows of the project
Discounts the cash flows
What is the IRR
Internal Rae of Return - sets NPV to zero
IRR Minimum Acceptance Criteria
Accept if IRR exceeds Required Rate of Return
IRR Ranking Criteria
Select alternative with highest IRR
What assumption comes with IRR?
Reinvestment Assumption - all future cash flows are assumed to be reinvested at the IRR
Advantage of IRR
Easy to understand
Disadvantages of IRR (4)
Does not distinguish between investing and borrowing
IRR may not exist
Multiple IRRs
Problems with mutually exclusive investments.
Two types of projects effected by IRR
Investment Project - negative cash flows are frontloaded, higher discount rate erodes NPV, invest if IRR > Hurdle
Financing Project - negative cash flows are backloaded, high discount rates increase NPV, invest if IRR < Hurdle Rate
Financing vs. Investment Projects
Investment - conventional, pay to invest in something that generates cash later on.
Financing - receive today, pay back later
Three approaches for Modified Internal Rate of Return (MIRR)
Discounting
Reinvestment
Combination
Discounting Approach
Discount all negative cash flows back to year zero and add them to initial cost
Reinvestment Approach
Compound any cash flows except for the first out to the end of the project, not taking any cash out until the end of the life.
Combination Approach
Both discounting negative CFs to year 0 and compounding all other CFs to the end of the project.
Independent Project
Must exceed a minimum acceptance criteria
Mutually exclusive
Rank all alternatives, select the best
Size/Disparity Problem
Associated with mutually exclusive projects, initial investments are substantially different
Payback Period
How long does it take the project to pay back its inital investment?
Minimum Acceptance Criteria and Ranking Criteria for Payback Period
Set by management
Advantages of Payback Rule (2)
Easy to understand
Biased towards liquidity
Disadvantages of Payback Rule (4)
Ignores TVM
Ignores CFs after payback period
Biased against long term projects
Project accepted based on payback criteria may not have a positive NPV.
Discounted Payback Period
How long it takes to payback initial investment taking TVM into account
Decision Rule Discounted Payback Period
Accept if it pays back on a discounted basis within then specified time
Profitability Index
Ratio between the present value of future expected cash flows and the initial amount invested in the project
Acceptance Criteria + Ranking Criteria (PI)
Accept if PI > 1 or select alternative with highest PI
PI Advantages (3)
Useful when investment funds are limited
Easy to understand and communicate
Correct decision when evaluating individual projects
PI Disadvantage
Problems with mutually exclusive projects
Depreciation Characteristics (3)
Not a real cash flow
A tax shelter and tax savings
Depreciation affects CF positively by reducing taxable income
Ways to calculate depreciation (2)
Straight line - initial asset cost divided by number of useful years.
Diminishing balance - constant rate applied to the asset’s beginning of year book value to identify deduction each year
Net Working Capital (3)
- WC is cash employed to run day-to-day operations, not consumed but rather employed for a period of time
- Increase in WC during a period means more cash is employed, vice versa.
- WC normally assumed to be recovered at the end of the project (terminal year).
Three major impacts of Tax
- Income tax represents cash outflow
- Tax shield
- Capital gains tax - lowers proceeds made from sale of an asset. capital loss may result in a tax saving
How to calculate operating cash flow? Bottom Up Approach
OCF = (R - C - D)(1-tc) + D
Opportunity Cost
Lost revenue from alternative uses
Real vs. Nominal Rate
Nominal = current price, real = adjusted for inflation
Assumption for Mutually Exclusive Projects with unequal lives
Replication at the end of a projects life w/ a replacement (identical)
Methods of analysing mutually exclusive projects (3)
Lowest common life
NPV in perpetuity - preferred method
Equivalent Annual Annuity - assumes project will be repeated
Types of Uncertainty (3)
Direct - Binary (significant government or competitor investment, etc.)
Direct - Diffuse (consumer demand, etc.)
Indirect (financial markets and access to capital, etc.)
Financial Break even
Sales volume that generates a NPV of zero
- Use II equation & PVIFA
Financial Option
Owner has the right but not the obligation to buy something in the future for a price set today
3 types of options
Expand, abandon, delay
4 things that need to be true for option values to exist in real investment analysis
Uncertainty
Learning
Flexibility
Irreversibility
The market value of a project is…
The sum of the NPV of the project without options and the value of the managerial options implicit in the project.
MV = NPV + option value
