Capital Investment Decisions Flashcards
capital budgeting
the process of identifying, analyzing, and selecting investments in long-term projects
capital budgeting applications include
-buying equipment
-building facilities
-acquiring a business
-developing a product or product line
-expanding into new markets
stages in capital budgeting
- identification and definition (most difficult)
- search
- information-acquisition: financial and nonfinancial measures are analyzed
- selection: using models such as NPV, IRR
- financing
- implementation and monitoring
steps in ranking potential investments
- determine the asset cost or net investment
- calculate estimated cash flows
- relate the cash-flow benefits to their cost
- rank the investments
what is a firm’s hurdle rate
the minimum rate of return on a project or investment that an investor is willing to accept
what are the three categories of relevant cash flows
- net initial investment
- annual cash flows
- project termination cash flows
depreciation tax shield
depreciation expense x tax rate
components of net initial investment
-cost of new equipment
-initial working capital requirements
-after-tax proceeds from disposal of old equipment
components of annual net cash flows
-after-tax cash collections form operations (not including depreciation)
-tax savings from deprecation deductions (depreciation tax shield)
components of project termination cash flows
-after tax proceeds from disposal of new equipment
-recovery of working capital (untaxed)
if the NPV of a project is positive
the project is desirable because it has a higher rate of return than the company’s desired rate
the internal rate of return
expresses a project’s return in percentage terms
the discount rate at which the investment’s NPV equals zero
if the IRR is higher than the company’s rate of return
the project is desirable
disadvantages of IRR
-direction of cash flows
-mutually exclusive projects
-varying rates of reutrn
-multiple investments
payback period
the number of years required to return the original investment
no accounting is made for the time value of money
if the cash flows are constant, the payback period formula is
initial net investment / annual expected cash flow
discounted payback method
used to account for the time value of money
profitability index
PV of future cash flows / net investment
if the profitability index is greater than 1
the project should be accepted
the required rate of return must be less than the IRR
when the risks of the individual components of a project’s cash flows are different, an acceptable procedure to evaluate these cash flows is to
discount each cash flow using a discount rate that reflects the degree of risk
A treasurer is in the process of determining whether she should invest a portion of her company’s pension plan assets in a publicly traded company. The treasurer has collected the following information on the company:
Current-year dividend = $1.50
Yearly dividend increase = 5%
Expected investor return = 10%
Current share price = $25.00
On the basis of the information provided above, the treasurer is justified in concluding that an investment in the company
Should be profitable if assumptions hold true.
The investment is projected to earn a good return, and the dividend is expected to grow from year to year. If these hold true, then the investment should be profitable.
The rankings of mutually exclusive investments determined using the internal rate of return method (IRR) and the net present value method (NPV) may be different when
multiple projects have unequal lives and the size of the investment for each project is different
The two methods ordinarily yield the same results, but differences can occur when the duration of the projects and the initial investments differ. The reason is that the IRR method assumes cash inflows from the early years will be reinvested at the internal rate of return. The NPV method assumes that early cash inflows are reinvested at the NPV discount rate.
A widely used approach that is used to recognize uncertainty about individual economic variables while obtaining an immediate financial estimate of the consequences of possible prediction errors is
sensitivity analysis
what statement is correct regarding the net present value (NPV) and the internal rate of return (IRR) approaches to capital budgeting?
if the IRR of a project is equal to the company’s cost of capital, the NPV must be zero.
What is the most satisfactory method of evaluating competing capital projects
NPV
If a project costing $50,000 and returning 14,000 per year for 5 years, what statement is true
IRR is greater than 10%
The total cash inflows are only $70,000 (5 × $14,000). Thus, whatever the discount rate, the NPV will be less than $20,000 ($70,000 – $50,000). The return in the first year is $14,000, or 28% of the initial investment. Since the same $14,000 flows in each year, the IRR is going to be greater than 10% (actually, it is almost 14%).
What is an advantage of using the payback method for capital budgeting?
more liquid projects are rated higher
Assume that an investment project’s assumed cash flows are not changed, but the assumed weighted-average cost of capital is reduced. What impact would this have on the net present value (NPV) and the internal rate of return (IRR) of this project?
NPV would increase, and IRR would not change.
