COMM 308chapter 13: Capital Budgeting, Risk Considerations, and Other Special Issues Flashcards
Capital expenditures
a firm’s investments in long-lived asset (can be tangible and intangible)
usually involve large amounts of money
the decisions are frequently irrevocable
Capital budgeting
the process by which a firm makes capital expenditure decisions
the process steps by which a firm makes capital expenditure decisions (capital budgeting)
(1) identifying investment alternatives
(2) evaluating these alternatives
(3) implementing the chosen investment decisions
(4) monitoring and evaluating the implemented decisions
how can securities reflect capital expenditure decisions?
if they messed up, people will know and will not think that investing in these companies is a good decision
security price decreases
Michael Porter’s five critical factors that determine the attractiveness of an industry
the five forces
entry barriers
the threat of substitutes
the bargaining power of buyers
the bargaining power of suppliers
rivalry among existing competitors
according to Michael Porter, what do firms have little control over after inception?
the attractiveness of the industry they are in
according to Michael Porter, what do firms have total control over?
over the manner in which they strive to create a competitive advantage within their industry
according to Michael Porter, what can firms do to obtain competitive advantage?
- Cost leadership: strive to be a low-cost producer
or
- Differentiation: offer “differentiated” products
Cost leadership: strive to be a low-cost producer
viable for firms that are able to take advantage of economies of scale, proprietary technology, or privileged or superior access to raw materials
investment outlays should be made in accordance with a firm’s potential advantage
Differentiation: offer “differentiated” products
Firms can provide products that are differentiated from others in several ways
–> The most obvious is to have a product that is itself unique by virtue of its physical or technological characteristics
–> However, firms can also differentiate their products by providing customers with unique delivery alternatives or by establishing a marketing approach that distinguishes their products from those of their potential competitors
Porter suggests that it is difficult to sustain a competitive advantage once one has been created, what must companies keep doing then?
companies must continually plan (and invest) strategically
Bottom-up analysis
based on the idea that a firm is simply a set of capex decisions
an investment strategy in which capex decisions are made in isolation, without considering general industry and economic trends or whether the firm should continue in this particular business
involves probabilities and estimates
Equipment replacement is a typical bottom-up analysis or top-down analysis?
why?
a typical bottom-up analysis
an engineer estimates the savings that will be realized by replacing one piece of equipment with another
A financial analyst then translates these savings into financial parameters to determine whether the replacement savings are worth the cost of the equipment
at no point does the engineer or the financial analyst consider whether the firm should continue in this business
top-down analysis
focuses on strategic decisions about which industries or products the firm should be involved in
looking at the overall economic picture
involves uncertainty which can’t be calculated using probabilities
In looking at bottom-up versus top-down analysis, what stays the same?
the capital budgeting framework
In looking at bottom-up versus top-down analysis, what is different?
the quality of the estimates
discounted cash flow (DCF) methodologies
techniques for making capex decisions that are consistent with the overriding objective of maximizing shareholder wealth
involves estimating future cash flows and comparing their discounted values with investment outlays required today
they are technically identical to the approaches used to evaluate bonds and preferred and common shares
The payback period method
defined as the number of years required to fully recover the initial cash outlay associated with a capital expenditure
we use a cutoff date
provides a useful intuitive measure of how long it takes to recover an investment and is sometimes used as an informal measure of project risk
shorter or longer payback periods are better?
shorter payback periods
how can the payback period method measure risk?
the quicker a firm recovers its investment outlay, the less risky the project is
drawbacks of the payback period method
- it disregards the time and risk value of money, because it treats a dollar of cash flow received in year 3 the same as those received in year 1, and so on
- the payback period does not account for the cash flows received after the cutoff date, which could be substantial for some long-lived projects
- the choice of the cutoff date is somewhat arbitrary and may vary from one firm to the next
The discounted payback period method
alleviates the first shortcoming of the payback period by accounting for the time value of money
the number of years required to fully recover the initial cash outlay in terms of discounted cash flows
Shorter periods are better, and projects with discounted payback periods before the cutoff date will be accepted
drawbacks of the discounted payback period method
ignores cash flows beyond the cutoff date
the cutoff date is somewhat arbitrary
The net present value (NPV) of a project
defined as the sum of the present value (PV) of all future after-tax incremental cash flows generated by an initial cash outlay, minus the present value of the investment outlays
the present value of the expected cash flows net of the costs needed to generate them
it is like the Real Estate class, if you can use excel, do it
Cash flows that have already been incurred in the NPV method
“sunk” costs and are ignored
they do not change as a result of the firm’s investment decision
incremental in capital budgeting
the change in revenues or costs resulting from the investment decision
risk-adjusted discount rate (RADR)
a discount rate set based on the overall riskiness of the project
what does a positive NPV mean for a firm?
add value to the firm
should be accepted because, by definition, a positive NPV implies that the PV of the expected future cash flows will exceed the cash outlay today
The internal rate of return (IRR)
the same as the yield to maturity (YTM) for a bond
the discount rate that makes the NPV equal to zero for a given set of cash flows
the discount rate that sets the PV of future CFs equal to the initial cash outlay
often called the “economic rate of return” of a given project
The general rule for IRR evaluation criteria
a firm should accept a project whenever the IRR is greater than the appropriate risk-adjusted discount rate (k) (usually the firm’s cost of capital)
as the discount rate increases, what happens to the NPV?
it decreases
when the NPV curve crosses the x axis (the horizontal axis), what does this mean for the IRR?
this means that that point of discount rate is our IRR
if the discount rate is more than the IRR, what happens to our NPV?
our NPV becomes negative
if the discount rate is less than the IRR, what happens to our NPV?
our NPV becomes positive
mutually exclusive projects
a situation in which the acceptance of one project precludes the acceptance of one or more alternative projects
the crossover rate
a special discount rate at which the net present value profiles of two projects cross (are equal)
at this discount rate, the NPV between two mutually exclusive project is the same
the slope of the NPV curve
reflects the change in the NPV as the discount rate changes
differences between the NPV and IRR decisions
the NPV decision depends on the discount rate, whereas the IRR decision does not
The NPV assumes that all cash flows are reinvested at one consistent discount rate
–> The IRR assumes instead that all cash flows are reinvested at the IRR
which assumption between the IRR and NPV is more realistic?
the NPV assumption
which method is more widely used to make capital budget decisions between the NPV and IRR?
NPV (74.65)
IRR is close at 68.4%
NPV versus IRR
Issue: Future cash flows change sign
NPV: NPV works the same way for both accept/reject and ranking decisions.
IRR: Multiple IRRs may result—in this case, the IRR cannot be used for either accept/reject or ranking decisions
NPV versus IRR
Issue: Ranking projects
NPV: Higher NPV implies greater contribution to firm wealth—it is an absolute measure of wealth
IRR: The higher IRR project may have a lower NPV, and vice versa, depending on the appropriate discount rate and the size of the project. For example, would analysts prefer an IRR of 100 percent on $1,000 or 20 percent on $1 million?
NPV versus IRR
Issue: Reinvestment rate assumed for future cash flows received
NPV: Assumes all future cash flows are reinvested at the discount rate. This is appropriate because it treats the reinvestment of all future cash flows consistently, and k is the investor’s opportunity cost.
IRR: Assumes cash flows from each project are reinvested at that project’s IRR. This is inappropriate, particularly when the IRR is high.
The profitability index (PI) index
another DCF approach used to evaluate capital expenditure decisions
a relative measure of project attractiveness
defined as the ratio of a project’s discounted net incremental after-tax cash inflows over the discounted cash outflows, which are usually the initial after-tax cash outlays
projects with ratios greater than one should be accepted because, by definition, they have positive NPVs
It is also obvious that larger ratios are favoured because their NPVs are higher
benefits of the PI over the IRR
the PI produces the same accept/reject decisions as do the NPV
the PI does not suffer from two of the weaknesses of the IRR, because it uses one consistent and reasonable discount rate and because it works even when future cash flows change signs
Like the IRR, the PI is attractive because it can be expressed as a percentage
One weakness that the PI shares with IRR
it is a relative measure and not an absolute measure of wealth, like NPV
when is the PI often used?
when firms are constrained by their capital budget
Independent projects
have no relationship with one another
interdependent projects
projects that are related such that accepting or rejecting one has an impact on the value of other projects under consideration
Projects with unequal lifespans can be compared by using which two approaches?
The chain replication approach
The equivalent annual NPV (EANPV) approach
contingent projects
projects for which the acceptance of one requires the acceptance of another either beforehand or simultaneously
the rule is to estimate the total NPV of all contingent projects and accept them if this total NPV is positive
The chain replication approach
involves finding a time horizon into which all the project lives under consideration divide equally and then assuming each project is repeated until they all reach this horizon
For example, if a firm is comparing a three-year project with a four-year project, it would assume the three-year project could be replicated four times and that the four-year project could be replicated three times (for a total of 12 years each)
It then finds the PV of all the replicated projects for each individual project and chooses the one that generates the highest NPV over the entire period, assuming the NPV is positive
The equivalent annual NPV (EANPV) approach
finds the NPVs of individual projects and then determines the amount of an annual annuity that is economically equivalent to the NPV generated by each project over its respective time horizon
