Finance Week 11 Flashcards
In the context of capital budgeting, explain in what circumstances it may be useful to use “annualized capital costs” to choose between two investment projects.
*EAC, equivalent annual cost
*Another possibility is to repeat the project _ times and compare the PV of costs.
When 2 mutually exclusive projects perform exactly the same function, w/ same revenue & same capacity, but w/ diff. costs & DIFF. LIVES
= PV / annuity factor
= the present value of a project’s total costs calculated on an annual basis that needs to be paid to recover the costs associated (with a machine)
Choose the project with the lower annualized capital cost, considered the fair annual rental (for the machine)
Simply comparing the PV of costs is misleading because the projects have different lives.
Net Present Value (NPV) investment rule
What is NPV? Link to the discount rate?
Why do we choose the project with the highest NPV?
Accept project: NPV>0
Reject: NPV<0
Indifferent/breakeven point: NPV=0
Difference between all the NPV of inflows and outflows. Discount cash flows to time 0
- Inverse relationship between discount rate & NPV, ie. as discount rate increases, NPV decreases
(on graph, also show NPV at breakeven point)
Choose project with highest NPV b/c it benefits shareholders the most by adding to their current wealth, according to standard corporate finance objectives.
5 advantages of NPV
- Measures by how much shareholders wealth increase so is in line with standard corporate finance objectives
- Uses ALL cash flows + takes into account the TIME VALUE of money by discounting cash flows
- Allows easy comparison and ranking of projects
- Allows comparison of mutually exclusive projects
- Takes into account the SCALE of projects
Timeline and sequence of cash flows for capital budgeting - 9 steps
Aka investment appraisal / strategic asset allocation
- Cost and refurbishment
- TAX BENEFIT of depreciation
- After-tax profit
- After-tax SALVAGE value
- Revenue from selling current ship (time 0)
- Net working capital
- recover everything at the end; sum of changes is 0 - Total cash flow in each year
- PV of cash flow using Discount factor
- NPV
Internal Rate of Return (IRR) investment rule
What is IRR?
*discount rate = opportunity cost of capital = REQUIRED rate of return
Accept project: if discount rate required < IRR
- b/c NPV becomes positive
Reject: if discount rate required > IRR
- b/c NPV becomes negative
The discount rate that makes NPV = 0.
Rate of return that makes you indifferent between choosing the project or not
4 problems with IRR
2 advantages of IRR
- For cash flows where there is a sign change, eg. 2 points where NPV = 0, there will be multiple IRR. Therefore, IRR rule is not applicable.
- Misleading when evaluating MUTUALLY EXCLUSIVE investments
- Does not take into account the APPROPRIATE TIMING of each cash flow (time value of money). The discount rate used is not the one required given the riskiness of the project. The IRR is simply the rate to make NPV = 0
- Does not take into account the SCALE of the project
- Straightforward and intuitive. Easy to understand
- Same as using NPV for projects w/ no sign change, not mutually exclusive
Payback period rule
*Case in which payback period is in between 2 years.
We assume that cash flows are PROPORTIONAL over time to calculate payback.
The amount of time required for investment to recover its initial cost, ie. project life resulting in NPV = 0
^add up the cash flows over time and stop at the point of time when recovered initial cost
- Compare payback period to a BENCHMARK period
Accept project: payback period < benchmark
Reject: payback period > benchmark
3 advantages of Payback period
4 disadvantages
- Easy to understand
- Adjusts for uncertainty of later/future cash flows
- Biased towards liquidity (liquidity shows you how to choose)
- Didn’t discount cash flows; ignores TIME VALUE of money
- Requires a BENCHMARK - an arbitrary cut-off point
- Ignores cash flows beyond cut-off date
- Biased against long-term projects, eg. R&D
