Ch. 10 - Capital Budgeting Flashcards
capital budgeting
- capital - long term assets used in production
- budget- plan that outlines projected expenditures during a period.
- capital budget - summary of planned investments of assets that’ll last more than a year
- capital budgetting- process of analyzing projects and deciding which ones to accept and include in the capital budget
how firms categorize projects
- replacement needed to continue profitable operations
- replacement to reduce costs
- expansion of existing products or markets
- expansion into new products or markets
- contraction decisions
- safety and/or environmental projects
- other (office building, parking lots, etc)
- mergers
First step in project analysis
- to estimate project’s estimated cash flows
- calculate evaluation measures: NPV, internal rate of return, modified internal rate of return, prof index, regular payback, discounted payback
NPV
- the present value of a project’s expected cash flows (including initial cost) discounted at the appropriate risk-adjusted rate.
- measures how much wealth the project contributes to shareholders.
- when deciding which projects to accept, MPV is generally the best single criterion
independent vs mutually exclusive
- cash flows for independent projects aren’t affected by other projects
- mutually exclusive are two different ways of getting the same result. if one is accepted the other has to be rejected.
Independent- if NPV > 0, accept project. accept both if both are positive NPV’s
ME- accept project with highest NPV. Reject if none has positive.
Internal Rate of Return
discount rate that forces the PV of the expected future cash flows to equal the initial cash flow
= to the discount rate that forces NPV to equal 0
-estimate of the rate of return the company would actually earn if it invested in the project
if IRR < cost of capital, stockholders suffer loss
3 ways to find:
1. trial and error to get the equation to solve to 0
2 calculator - press IRR
multiple IRR’s
normal cash flow pattern can have at most 1 postive IRR. signs change only once
nonnormal - signs change more than once. possible to have multiple IRR’s
if sign changes more than once, don’t even calculate IRR
Problems when using IRR for mutually exclusive projects
if projects are mutually exclusive, choose the project with the higher NPV (even if other IRR is higher) because it will generate the most wealth.
if IRR > cost of capital —> accept it
crossover rate
cost of capital at which the NPV profiles for two projects intersect. one has a higher NPV below the rate but the other has higher above the rate.
calculate the IRR of the difference between the cash flows. if cost of capital is < crossover rate - chose
Modified Internal Rate of Return (MIRR)
- based on the assumption that cash flows are reinvested at the WACC
Steps: 1. find PV at each time and sum them
2: find the FC of each inflow, compounded at WACC at the terminal year (last inflow) then sum them
3. use calculator and put 2’s answer as FV
Advantages: there can never be a multiple and assumes cash flows are reinvested at the cost of capital. IRR < MIRR < NPV
profitability index
- measures how much value a project creates for each dollar of the project’s cost
- project is acceptable if PI is > 1.0
payback period
of years needed to recover the funds invested in a project from its operating cash flows
3 flaws: TVM is ignored bc the $$ received in different years are all given the same weight, cash flows beyond the certain year aren’t given any consideration, and just says how long it’ll take to recover an investment.
NPV and IRR say how much wealth a project adds or how much a rate of return exceeds cost of capital
discounted payback
cash flows are discounted at WACC and then those are used to find payback so TMV isn’t ignored.
the shorter the payback, the greater the project’s liquidity, also a risk-indicator bc cash flows expected later are riskier than sooner
comparing the methods
NPV- best method. provides direct measure of the value a project adds to shareholder wealth
IRR and MIRR- measure profitability as a % rate of return. MIRR is better bc it measures reinvested cash flows too
PI- measures profitability in relation to the amount of investment
payback and discounting payback- indicate a project’s liquidity and risk. long payback means less liquid
Qualitative factors
chances of tax increase, war, liability suit, etc should also be considered
quantitative methods should be considered an aid to decisions and not a substitute for judgement
