Chapter 5 Flashcards
(20 cards)
What is Capital Budgeting
- Long-term decisions; involves large expenditures
- Very important to firm’s future
- Analysis of potential additions to fixed assets
Steps to capital budgeting
1) Estimate cash flows (inflow and outflow)
2) Assess riskiness of cashflows
3) Determine the appropriate cost of capital
4) Find NPV or IRR
5) Accept project if NPV >0 or IRR>WACC
Independant Projects
Cash flows of one are unaffected by the acceptance of the other
Mutually Exclusive Projects
Cash flows of one can be adversely impacted by the acceptance of the other
Normal Cash Flows
Initial outlay (negative cash flow or cash outflow) followed by a series of positive cash inflows
Non-Normal Cash Flows
Two or more changes of signs. Most common: Initial outlay (negative CF), then string of positive CFs, then cost to close project.
Present Value
- What money at some point in the future is worth today
- The PV shows the value of cash flows in terms of today’s purchasing power
Discounting
Finding the PV of a cash flow or series of cash flows when compound interest is applied
Ordinary Annuity
Fixed payment at intervals end of period
Annuity Due
Fixed payment at intervals beginning of period
NPV method assumes CFs are reinvested at the
WACC
IRR Method assumes CFs are reinvested at the
IRR
Strengths of Payback
- Provides an indication of projects risk and liquidity
- Easy to calculate
Weaknesses
- Ignores the time value of money
- Ignores cashflows occuring after payback period
Subsidiary vs Parent differences in perspectives due to
- Tax differentials
- Regulations that restrict remittances
- Excessive remittances
- Exchange rate movements
Factors to consider in Multinational Capital Budgeting *
1) Financing arrangement
-Financing costs are usually captured in the discount rate e.g WACC. However, when foreign projects are partially financed by foreign subsidiaries, a more accurate approach is to
• Separate the subsidiary investment
• Consider any foreign loan payments as cash
outflows
2) Exchange rate fluctuations
3) Interest rates in foreign markets
4) Blocked funds
-Some countries require that the earnings
generated by the subsidiary be reinvested locally for at least a certain period of time before they can be remitted to the parent
5) Host government incentives such as tax incentives etc
Adjusting Project Assessment Risk
When an MNC is unsure of the estimated cash flows of a proposed project, it needs to incorporate an adjustment for this risk
• One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger the discount rate that should be applied to the cash flows.
Country Risk
Potentially adverse impact of a country’s environment on an MNC’s cash flows
Political Risk Factors
- Attitude of consumers in the host country
- Actions of host government
- War
- Corruption
Financial Risk
- Indicator of economic growth
