Chapter 21 Flashcards
Capital Budgeting
Focus is long-run
Concerns both the amount and timing of CF
These decisions are mostly concerned with whether or not to take on various projects ( expansion, new equipment)
Capital Budget Process
2 Concerns
Concerned with:
- Whether to acquire a new asset
- How to finance it (borrow, raise equity, operations)
These 2 decisions are independent
Capital Budget Methods
NPV
IRR
PAYBACK
AARR
NPV and IRR are DCF
What does DCF do?
3 things
Measure all expected future cash inflow and outflow of a project discounted back to the present
Key feature is TVM
TVM is the opportunity cost from not having money today
Example: 1.00 invested today is worth 1.10 in the future.
RRR
DCF use RRR-the minimum acceptable annual rate of return on an investment usually set by upper mgt
RRR - discount rate, hurdle rate, cost of capital
Riskier projects require higher discount rates
Identification of CF
3 Things
TIP
Inception - asset cost, working capital, salvage value of old asset, tax effect or disposal)
Periodic - receipts from sales, pymt for production or SG&A cost, income taxx, depr tax shield. These occur and the end of period
Terminal - Salvage value of asset, net effect of tax effect, working capital return
NPV Calculation Method and Definition
the difference between PV of cash inflow and outflow associated with project
Estimate future cast inflow and outflow
select appropriate discount rate
discounting the flow back to today
accepting posItive NPV not negative NPV
What does the IRR Method do?
Calculate the discount rate at which an investments PV of all expected cash inflow equals the PV of all expected cash outflows. where NPV=0
A project is accepted only if IRR= or exceeds the RRR
Comparing NPV and IRR Methods
NPV reinvest at RRR
IRR reinvest at IRR
NPV expressed in $
IRR expressed in %
IRR projects cannot be added or averaged to present the IRR or a combination of projects
NPV can be used when RRR varies over the life of the project
What does the Payback Method Do?
Measures the time it will take to recoup in the form of expected future CF, the net initial investment
dont distinguish source of CF just like NPV and IRR
shorter pybk is preferred
easier to explain
2 weakness: don’t consider TVM or CF after pybk
Payback Calculation
Uniformed
Non-uniformed
Uniformed CF
Net initial investment/uniform increase annual future CF
Non-uniformed CF
add CF pd-by-pd until the initial investment is recovered
count the # of pd included for pybk pd
adjust pybk to add TVM by discount the expected future CF b4 doing calculation
What is the AARR Method?
average annual (accrual acctg) income of project/ a measure of the investment in it
measure of the investment is different in every company
called acctg rate of return
AARR like IRR - rate of rtn as %
IRR is better
AARR Formula
Increase in Expected average annual after tax operating income (Don’t forget to subtract the depreciation expense and add back depreciation tax shield)/Net Initial Investment
AARR Good and bad
Firm vary in how AARR is figured - Bad
Easy to understand and use number from fin. state. - GOOD
don’t track CF-BAD
Ignore TVM - BAD
When results differ, use NPV; it’s more consistent way to maximize company value
3 Tax Effects
All peridoic CF
Sales you get to keep 1-tax rate
Expense you only have to pay 1-tax rate
Depreciation tax shield (tax rate*depreciation)
gains has a negative tax effect
losses has a positive tax effect
