Finance - Capital Budget - Investment Decision Flashcards
What is the most common decision used for capital budget
- Using NPV which adjusts the cash flow based on the time value of money
What is the acceptance rule when using NPV
- You should accept the NPV of the project when it has a positive balance - from a quantitative analysis
- $0 NPV is expected to be when there is an equal return to the discount rate
What are the merits and limitations of using NPV for calculating the capital budget
Merits
1. Consider the time value of money
2. Calculations are based on the absolute dollar value of investment opportunities
3. Possible to use variable discount rates, differing levels of risk
Limitation
1. Long-term cash flow forecasting may be difficult because assumption prediction
2. Asumme that cash flow occur at the end of the period
Explain what is sensitivity analysis and how it is used for capital budget
Sensitivity analysis - is a systematic test resulting in identifying & varying the values of key assumptions to understand the range.
- Is a future-focused projection used by the manager to actively anticipate the impact on uncertainties
“ What if analysis”
Explain how the initial rate of return is used for capital budgeting and when should it be accepted
- Initial rate of return (IRR) is the discount rate for the project in which NPVis equal to $0
- Relevant cash flow is allocated for each period of project life
- Complex to calculate IRR using tax shield formula
When to accept
- using IRR, when the IRR rate is greater than the discount rate. If lower, then reject
Provide the merits and limitations when using IRR
Merit
- it considers the time value of money
- Can be easily understood
Limitation
- The IRR method can have more than one result. Periodic cash flow is positive and negative throughout the life of the project
- It cannot be used to rank mutually exclusive projects because IRR assumes that project cash flow is reinvested at the project
- IRR does not indicate the impact of the project on firm value in absolute dollar
Explain how is payback period used when determining capital budget and determining the rule of acceptance
- Payback period - the amount of time needed to pay back the initial investment of the project, simplest budgeting techniques. More uncertain longer payback period
When to accept
- The company should accept the project only when the payback period is less than the target payback period
“Usually 3 years or less, depends on future cash flow”
What is the formula for payback period for even and uneven cash flow
Even cash flow
Payback period = A/B
A - Initial investment
B - Cash inflow per period
Ex. Requiring initial investment of $117,000,000
After tax generated per year of $25,000,000
117,000,000 / 25,000,000 = 4.68
Uneven cash flow
- Cash inflow for project are uneven over the time frame, cumulative net after tax cash
Payback period = A+B/C
A - Last period with negative cumulative cash flow
B - Absolute value of cumulative cash flow at the end of the period
c = Total cash flow during the period right after period A
How is the discounted payback period used
- It is a formula used to calculate the length of time to recover an investment based on its discounted cash flow
- Apply discount rate to cash flow, taking into consideration the time value of money
What are the merits and limitations of the payback period
Merits
1. It is very simple to calculate and its result are intuitive and easy to understand
2. It can be measure of risk inherent in a project, assuming the longer payback period is an indication of higher uncertainty
3. Highlights liquidity
Limitation
1. It does not take into account the time value of money, which can lead to wrong decision
2. It does not take into account the cash flow that occurs after payback period
3. Does not consider the value to be added to the company if the project is to be accepted
