Chapter 21 Flashcards
Capital Budgeting:
Working Capital:
The process of making long-run planning descision for investments in projects (Controll tool that spans multiple years)
-It considers all of the cash flow in the life of the investment
The difference between current assets and current liabilities represents the capital used in the firms day to day operations
Dimensions of Capital Budgeting:
- Project-by-project (one projcet spans mutlitple accounting periods)
- Period- by period (one period cotains multiple projects)
Relevant cash flows in DCF analysis
3 Cash flow categories:
The differences in expected future cash flow as a result of making an investment
- Net initial investment
A) Initial equipment investment
B) Initial working capital investment - Cash flow from Operations
A) Annual after-tax cash flow from recurring operations
B) Income tax cash saving from recurring operations - Terminal Dispoal of investments
A) After-tax cash flow from terminal dispoal of equipment
B) After-tax cash flow from terminal recovery of working capital investment
Four Capital Budgeting Methods:
- Net Present Value (NPV)
- Internal Rate of Return (IRR)
- Payback Period
- Accural Accounting Rate of Return
Discounted Cash Flows measure:
What two methods:
Key Features:
All expected future cash inflows and outflows of a project discounted back to the present point in time
- NPV
- IRR
-Time value of money (interest) dollar recieved today is worth more than a dollar recived in the futue. (think opportunity cost) [The longer the investment, the more risk]
-Both use RRR (Required rate of return)- which is internally set
NPV method:
Net Present Value (NPV): Calculates expected gain/loss by discounting future cash flows to present using the Required Rate of Return (RRR).
Accept project if discounted inflows ≥ outflows → ROI ≥ RRR.
Only zero or positive NPV projects are acceptable—return exceeds cost of capital.
Methods:
-Discount cash flows yearly
-Use annuity tables
Steps:
1.Sketch relevant inflows/outflows
2.Convert to present values
3.Sum to find NPV
4.Positive/zero NPV = accept, negative NPV = reject
Do NPV Method exercise
please and thank you
Internal Rate of Return Method
nternal Rate of Return (IRR): The discount rate that makes NPV = $0 (i.e., PV of inflows = PV of outflows).
Accept project if IRR ≥ Required Rate of Return (RRR).
Also known as the time-adjusted rate of return.
Typically calculated using a financial calculator or software due to trial-and-error method.
Steps:
1.Choose a discount rate and calculate NPV
2.If NPV < 0, try a lower rate
3.Repeat until NPV = 0
IRR Algerbaic annuity method :
Formula=
Annuity rate= net initial investment/annual cash inflow
For example, a company that initially invests $379,100 and expected operating income to increase by $100,000 for the next 5 years. What is the annuity rate? What is the discount rate?
Annuity Rate = 379,100
100,000
= 3.791
Discount Rate = 10% per present value of annuity $1
Do IRR exercise
Please and thank you
4 Comparison of NPV and IRSS
- NPV analysis is genuinly prefered
- Npv expess the computation in dollars, not in percentage which is easier to interpret
- NPV value can always be computed for a project
- NPV method can be used when the RRR varies over the life of a project
Sensitivity Analysis:
Helps managers to
Useful to compare how:
-focus on variable that are sensitive or have potential to change.
The evaluation of the porject will change if these is change in:
A- Projected cash flows
B- Timing of the cash flows
C- Required rates of return
Let A = Annual cash inflow and let NPV = $0. Net initial investment is $379,100, and present value factor at a 8% required rate of return for a five-year annuity of $1 is 3.993. Then,
NPV = $0
3.993A - $379,100 = $0
3.993A = $379,100
A = $94,941
Income tax and capital budgeting:
Income taxes are:
Marginal Tax Rate:
Operating cash flow must be considered on:
After tax saving =
Mandatory cash disbursements and influence the amount and timing of cash flows
The rate paid on any additional amount of pretax income {If a company is taxed 15% of the first $50,000 and then 20% on amount above, the company would then use 20% as the marginal tax rate because all additional income will be taxed at this rate}
an after-tax basis
Total cash flow * (1-tax rate)
A company profits $100,000 in a province with a marginal tax rate of 35%. What amount is retained after tax accruals?
$100,000 x (1 – .35) = $65,000
Capital Cost Allowance (CCA)
Capital Cost Allowance (CCA): A tax deduction for depreciable property (e.g., buildings, equipment) used in business.
CRA does not allow GAAP-based depreciation for tax purposes.
Instead, CRA permits CCA to determine taxable income.
Ensures consistent treatment across companies.
CCA typically follows a declining balance method for most asset classes.
Unamortized Capital Cost (UCC):
Original capital expenditure - capist cost allowances
CRA limits the rate of CCA to half of the regular rate in the first year (half-year) rule for most assets
Payback Method
Benefit:
Weaknesses:
Variation:
Projected accepted if:
Measures the time it will take to recoup, in the form of expected future cash flows, the net initial investment in a project
Shorter payback periods are preferable (The greater the risk, the shorter the payback period)
- Easy to understand
- Highlights liquidity
- Fails to recgonize time value of money
- Does not consider the cash flow beyond the payback point
- Uniform Payback period = net initial investment/ uniform increase in annual future cash flow.
- Non-uniform annual cash flows
Computation takes a cumulative form, inflows accumulated until net initial investment recovered
Project accepted if payback period shorter than the cutoff period, rejected if higher
Do a payback method exercise uniform
please and thanks
do payback method non uniform
thank you
Accural Accounting Rate of Return
Formula
Benefits:
Divides an accrual accounting measure of average annual income of a project by an accrual accounting measure of its investment
Increase in avg annual operating income/net intial investment
Increase in avg annual operating income= after tax income- depreciation
- Easy to understand
- Uses numbers reported in the financial statements
- Firms vary in how they calculate AARR
- Does not track cash flows
- Ignores time value of money
Do an AARR exercise
Thank you.
