Ch 2, Module 8 Flashcards
Define “capital budgeting
process for evaluating and selecting the long-term investment projects of the firm
accept a project if its profitable
When is a project considered profitable?
if the sum of the PV of CFs is greater than today’s cost
What is the “direct effect” as it relates to cash flow effects and capital budgeting?
when a company pays out cash, receives cash, or makes a cash commitment that is directly related to the capital investment
it has an immediate effect on the amount of cash available
What is the “indirect effect” as it relates to cash flow effects and capital budgeting?
transactions which are indirectly associated with a capital project or which represent a NONCASH activity that produces cash benefits or obligations
Ex: depreciation is a noncash expense but its tax deductible (i.e. reduces the amount of taxable income) so depreciation expense x tax = dollars saved
What is the “net effect” as it relates to cash flow effects and capital budgeting?
the total of the direct and indirect effects of cash flows from a capital investment
= sum of PV of CFs - Today’s cost
a postive number means you have greater inflows = profitable
How are inflows and outflows calculated on disposals of assets
SP - NBV = G/L x tax = outflow/inflow
working capital =
CA - CL
What is more relevant to capital budgeting: pretax CF or after tax CF?
after-tax CF
calculation for After-tax CF
= Pretax CF (aka EBT) x (1-T) = inflow
What is NPV
“net present value” = sum of PVFCFs - Cost
it’s profit (positive) /loss (negative)
You want to purchase or invest in a capital asset that will yield returns in an amount in excess of a mgt-designated hurdle rate
How to calculate NPV
- Calculate After-Tax CFs = Annual net CF x (1 - Tax Rate)
- Add depreciation [if there is a tax shield] = Depreciation x tax rate
- –ignore depreciation (unless tax shield) and interest expense - Multiply result by appropriate PV of an annuity (essentially discount the CFs)
- Subtract initial CF
What is the relationship between IRR and NPV
a postive NPV means that the IRR > hurdle rate
What is the difference between IRR and NPV in terms of the rate for required return
NPV may incorporate many types of hurdle rates, such as the cost of capital, the interest rate of opportunity cost, or some other minimum required rate of return. All rates are determined by MANAGEMENT
IRR does NOT allow adjustments to rate
When using NPV analysis, what might cause mgt to adjust the required rate of return
- increased risk
- increased inflation
What are the advantages and limitations of the NPV?
Advantages - flexible and can be used when there is no constant rate of return required for each year of the project. Also, measure p/l in $’s
Disadvantage - even though considered the best single technique for capital budgeting, it still does not provide the true rate of return on the investment. It only can indicate whether an investment will earn the hurdle rate used in the NPV (the estimate on the hurdle rate will have to be accurate)
