Financial Decision Models Flashcards
Cash flow effects
direct effect - when a company pays out cash, receives cash, or makes a cash commitment that is directly related to the capital investment, that effect is termed the direct effect; it has an immediate effect on the amount of cash available
indirect effect - transactions which are indirectly associated with a capital project or which represent noncash activity that produces cash benefits or obligations are termed indirect cash flow effects
net effect - the total of the direct and indirect effects of cash flows from a capital investment
Stages of cash flows
cash flows exist throughout the life cycle of a capital investment project; cash flows are categorized in 3 general stages: inception of the project, operations, and disposal of the project
pre-tax cash flows - the traditional computation of an asset’s value is based on the cash flows it generates; thus, an investment’s value is often based on the present value of the future cash flows that investors expect to receive from the investment; larger cash outflows than inflows may indicate that a project is unprofitable
after-tax cash flows - these are relevant to capital budgeting decisions and are computed using one of two methods (see book for example); operating cash flow differs from net income because noncash expenses like depreciation must be added back to net income to get to cash flow
What is working capital?
it is current assets minus current liabilities
What is the discounted cash flow method (DCF)?
the objective is to focus the attention of management on relevant cash flows appropriately discounted to present value
discounted cash flow methods frequently use a single interest rate assumption, which is often unrealistic because, over time, as management evaluates its alternatives, actual interest rates or risks may fluctuate
What is the net present value method (NPV)?
the objective is to focus decision makers on the initial investment amount that is required to purchase (or invest in) a capital asset that will yield returns in an amount in excess of a management-designated hurdle rate
NPV requires managers to evaluate the dollar amount of return rather than percentages of return (as with IRR) or years to recover principal (as with payback methods) as a basis for screening investments
NPV is calculated as follows:
1) estimate all direct and indirect after-tax cash flows (both inflows and outflows) related to the investment, accounting for the depreciation tax shield but ignoring financing costs already captured through the discounting process
2) discount all cash flows (inflows and outflows) to present value using the appropriate discount factor based on the hurdle rate and the timing of the cash flows
3) compare the present values of the inflows and outflows
if the NPV is positive –> make investment
if the NPV is negative –> do not make investment
if the NPV is zero –> management is indifferent
rates may be modified (generally increased) to adjust for risk and inflation; a higher hurdle rate discounts future cash flows more, creating a smaller present value and making it more difficult to accept a project; a higher hurdle rate and/or increased future cash flows can be used to adjust for high inflation
the NPV method is considered to be superior to the IRR method because it is flexible enough to handle inconsistent rates of return for each year of the project
while the NPV method is the best technique to use for capital budgeting and can be used when there is no constant rate of return required each year, it is limited by not providing the true rate of return on the project
What is the profitability index?
it measures cash-flow return per dollar invested; the higher the profitability index, the more desirable the project
profitability index = present value of cash flows / cost (present value) of initial investment
What is internal rate of return (IRR)?
it is the expected rate of return of a project; it determines the present value factor (and related interest rate) that yields an NPV equal to zero (the present value of the after-tax net cash flows equals the initial investment on the project); the IRR method focuses the decision maker on the discount rate at which the present value of the cash inflows equals the present value of the cash outflows (usually the initial investment)
while the NPV method highlights dollar amounts, the IRR method focuses decision makers on percentages
the targeted rate of return or hurdle rate is predetermined and is compared with the computed IRR
IRR > hurdle rate = accept
IRR < hurdle rate = reject
IRR = hurdle rate = indifferent
some limitations of IRR are:
unreasonable reinvestment assumption (cash flows generated by the investment are assumed to be reinvested at the IRR)
inflexible cash flow assumptions (IRR is less reliable than NPV when there are several alternating periods of inflows/outflows or if the amounts of cash flows differs significantly)
evaluates alternatives based entirely on interest rates (doesn’t consider the dollar impact of the project)
What is payback period method?
it is the time required for the net after-tax operating cash inflows to recover the initial investment in a project
the payback period method focuses decision makers on both liquidity and risk; the payback period method measures the time it will take to recover the initial investment in the project, thereby emphasizing the project’s liquidity and the time during which return of principal is at risk; the payback method is often used for risky investments; the greater the risk of the investment, the shorter the payback period that is expected/tolerated by the company
assuming equal annual cash flows, the formula for calculating the payback period is as follows:
payback period = net initial investment / average incremental cash flow
when the cash flow is not even, the payback period is calculated differently. Once the period falls between years (ex. more than 2 but less than 3), you take the amount of money left to reach the payback and then divide it by the amount of money for the year. You take this percentage and make it a decimal and add it to however many years have already been calculated
advantages of the payback method: it is easy to use and understand and emphasis on liquidity
disadvantages of the payback method: TVM is ignored, reinvestment of cash flows is not considered, total project profitability is neglected, and project cash flows occurring after the initial investment is recovered are not considered
What is the discounted payback method?
the object is to evaluate how quickly new ideas are converted into profitable ideas
the advantages and limitations of discounted payback are the same as the payback method (except that discounted payback incorporates TVM); both focus on how quickly the investment is recouped rather than overall profitability of the entire project
if needed on the CPA exam, the following formulas are how to calculate factors if they are not given on the exam
PV of $1: PV = FV / (1 + r)^n
FV of $1: FV = PV (1 + r)^n
What is economic value added (EVA)?
it ensures that profitability and performance are measured in comparison to changes associated with all capital, debt, and equity; EVA is expressed as an amount and is considered a form of economic profit
EVA = net operating profit after taxes (NOPAT) - required return
where: required return = investment * WACC
positive EVA = economic profit and strong performance
negative EVA = economic loss and poor performance
