Chapter 14 The Basics of Capital Budgeting Flashcards
What are Capital Budgeting decisions?
What is another term for this?
Decisions involving the listing of all capital investments (projects) to be undertaken in the future.
The process of selecting a business’s capital (long-term asset) investments.
Long-term (fixed) asset acquisition decisions involving expenditure of capital funds.
Issue if too little is invested in fixed assets?
technological obsolescence and inadequate capacity
What are the 5 Project Classifications
Category 1 Mandatory replacement
Category 2 Discretionary replacement
Category 3 Expansion of existing services or markets
Category 4 Expansion into new services or markets
Category 5 Environmental projects
What are the four steps of capital budgeting financial analysis?
- estimate the expected cash flows (most critical and difficult step)
- initial cash outlay (cost)
- operating flows
- terminal (ending) flow - assess the riskiness of those flows (project’s riskiness)
- estimate the appropriate cost-of-capital discount rate (opportunity cost of capital or discount rate)
- determine the project’s profitability and breakeven characteristics. (measure the financial impact).
What is the most critical and most difficult step in analyzing a project?
Estimating the incremental can flows that the project will generate
What is capital budgeting?
the process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments. (Forecasting costs is best for lowest possible financing costs and availability of funds as they are needed).
What should be considered in incremental cash flows?
Opportunity costs (the cashflows forgone by using an asset) and Other projects (impacted by "the project")
-sunk costs (cash outlays that cannot be recouped) are not included
What are tax laws?
How do tax laws affect investor owned firms (3 ways).
Tax laws are Tax laws are the legal rules and procedures governing how federal, state and local governments calculate the tax you owe.
Taxes 1) Reduce a project’s operating cash flows
2) tax laws prescribe depreciation expense that can be taken in any year
3) Taxes affect a project’s salvage value cash flow
What might a project have that is not accounted for in the estimated cash flows?
Strategic value ( at a minimum, strategic value should be noted and considered qualitatively in the analysis)
What changes are required in Capital Projects when there are additional investments added in fixed assets ?
What do the changes represent and where is it included?
Changes in current accounts in addition to the investment in fixed assets.
The changes represent a cash flow that must be included in the analysis .
What should be considered in project analyses and what is the best procedure?
The effects of inflation should be considered. The best procedure is to build inflation effects directly into the component cash flow estimates.
What is time breakeven and what is it measured by? What insights does time breakeven provide to managers?
Time breakeven is measured by payback period and provides managers with insights concerning a project’s liquidity and risk.
What is project profitability assessed by?
ROI Return on Investment measures. (most common) Net Present Value and Internal Rate of Return
What is Net Present Value and what does it do?
NPV - the sum of the present values of all the project’s net cash flows when discounted at the project’s cost pf capital.
It measures a project’s expected dollar profitability.
What does a NPV greater than 0 indicate?
the project is expected to be profitable after all costs including the opportunity cost of capital. The higher the NPA the more profitable the project
Internal Rate of Return (IRR)
what does it measure?
The discount rate that forces a project’s SPV to equal zero.
It measures a project’s expected rate of return. (If a project’s IRR is greater than its cost of capital, the project is expected to be profitable. the higher the IRR the more profitable the project.
What do the NPV and IRR profitability measures provide?
Measures provide identical indications of profitability, a project that is judged to be profitable by its NPV will also be judged profitable by its IRR.
When mutually exclusive projects are being evaluated, how might a NPV rank differently (higher) than IRR?
This difference can occur because the two measures have different reinvestment rate assumptions. IRR assumes that cash flows can be reinvested at the project’s IRR. NPV assumes that cash flows can be reinvested at the projects’s cost of capital.
What is modified internal rate of return (MIRR)
forces a projects cash flows to be reinvested at the projects cost of capital and is a better measure of a project’s percentage rate of return than the IRR
What is the Net Present Social Value (NPSV) Model
formalizes the capital budgeting decision process for not-for -profit firms.
What do firms use to subjectively incorporate a large number of factors including financial and nonfinancial, into the capital budgeting decisions process
project scoring
what is a key element in capital budgeting? (comparing actual results with predicted results, managers can improve both operations and the cash flow estimation process)
post-audit
capital budgeting techniques, what are they used for?
used for a wide variety of settings in addition to project evaluation.
Capital budgeting decisions
the process of selecting a business’s capital (long-term assets) investments. The list of investments chosen constitutes a business’s capital budget.
Incremental cash flow
the business’s cash flows in each period if the project is undertaken minus the cash flows if the project in not undertaken
CFt = CFt(business with project) - CFt(business without project)
A cash flow that arises solely from a project that is being evaluated and hence should be included in the project analysis
terminal value
when a project’s cash flows are arbitrarily truncated, an estimate of the value of the cash flows beyond the truncation point.
salvage value
the expected market value of an asset (project) at the end of its useful life.
sunk cost
a cost that hs already occurred or is irrevocably committed. Sunk costs are nonincremental to project analyses and hence should not be included.
non incremental cash flow
a cash flow that does not stem solely from a project that is being evaluated. Nonincremental cash flows are not included in a project analysis
strategic value
the value of future investment opportunities that can be undertaken only if the project currently under consideration is accepted.
Return on Investment (ROI)
the estimated financial return on an investment. In capital budgeting analysis, ROI can be measured either in dollar or percentage (rate of ) return.
payback period
the number of years it takes a business to recover its investment in a project ;without considering the time value of money.
Modified internal rate of return
A project ROI measure similar to IRR but using the assumption of reinvestment at the cost of capital .
project scoring
an approach to project assessment that considers both financial and non financial factors.
what is the role of financial analysis for investor-owned businesses?
identifies those projects that are expected to contribute to shareholder wealth
post audit
the feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations
what is the role of financial analysis for not-for-profit businesses?
identifies a project’s expected effect on the business’s financial condition. (What is needed in the community?)
How is cash flow timing analyzed?
- (daily)(costly to estimate) exactly as they are expected to occur
- often approximated by annual flow
In Cash Flow Estimation, what is Project Life? (time wise)
- often unknown
- typically set for 5-10 years
- often truncated(shortened) if long
What in Cash Flow Estimation is included and not included
Does not include - sunk costs
Includes - opportunity costs (the loss pf potential gain from other alternatives when one alternative is chosen) for capital
-opportunity costs for other resources
What breakeven analysis is used in project analysis?
- time breakeven
- input variable breakeven
In Input variable breakeven what does it consist of?
- volume (4142 scans versus 5000 expected)
- net revenue (73.13 per scan versus $80 expected).
What are the benefits and disadvantages of time breakeven and how it is determined?
Benefits - shorter pay back period = more quickly funds will be amiable for other
-shorter payback period are less risky
Disadvantages
- ignores all cash flows that occur after the payback period
- ignores opportunity costs associated with the capital
Determined using Cumulative Cash Flows
