Financial Decision Models Pt. 1 Flashcards
Cash flows are categorized in 3 general stages
inception of the project (time period zero): both direct and indirect cash flow effects occur at the time of the initial investment; the initial cash outlay for the project is often the largest amount of cash outflow of the investment’s life
operations: the cash flows generated from the operations of the asset occur on a regular basis; these cash flows may be the same amount every year (an annuity) or may differ; depreciation tax shields create ongoing indirect cash flow effects
disposal of the project: if the asset is sold, there is a direct effect for the cash inflow created on the sale and an indirect effect for the taxes due (in case of a gain) or saved (in case of a loss)
Under the inception stage of cash flows, there are 2 key areas
working capital requirements - working capital = current assets - current liabilities; when a capital project is implemented, the firm may need to increase or decrease working capital to ensure the success of the project
disposal of the replaced asset - 1) asset abandonment: if the replaced asset is abandoned, the net salvage value is treated as a reduction of the initial investment in the new asset; the abandoned asset’s book value is considered a sunk cost, and therefore not relevant to the decision-making process; the remaining book value (for tax purposes) is deductible as a tax loss, which reduces the liability in the year of abandonment; this tax liability decrease is considered a reduction of the new asset’s initial investment 2) asset sale: if a new asset acquisition requires the sale of old assets, the cash received from the sale of the old asset reduces the new investment’s value; if a gain or loss (for tax purposes) exists, there is also a corresponding increase or decrease in income taxes; the amount of income tax paid on a gain on a sale is treated as a reduction of the sales price (which increases the initial expenditure); conversely, a reduction in tax resulting from a loss on a sale is treated as a reduction of the new investment
Calculation of pre-tax and after-tax cash flows
pre-tax: 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: after-tax cash flows are relevant to capital budgeting decisions and are computed using 1 of 2 methods; operating cash flow differs from from net income because noncash expenses like depreciation must be added back to net income to get cash flow
Discounted Cash Flow (DCF)
DCF valuation methods are techniques that use time value of money (TVM) concepts to measure the present value of cash inflows and outflows expected from a project; the objective of the DCF method is to focus the attention of management on relevant cash flows appropriately discounted to present value; DCF methods are widely viewed as superior to methods that do not consider the TVM; however, DCF methods do have an important limitation - they frequently use a single interest rate assumption; this assumption is often unrealistic because, over time, as management evaluates its alternatives, actual interest rates or risks may fluctuate
Net Present Value Method (NPV)
the objective of the NPV method 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 or years to recover principal as a basis for screening investments
the investment decision is based on whether the NPV is positive or negative; positive = make investment
negative = don’t make investment
zero = management is indifferent about accepting or rejecting the project
advantages: can be used when there is no constant rate of return required for each year of the project
disadvantages: even though it’s considered the best single technique for capital budgeting, it is limited by not providing the true rate of return on the investment; it purely indicates whether an investment will earn the hurdle rate used in the NPV calculation
Rates may be modified (generally increased) to adjust for:
risk and inflation (also affects cash flows)
What is capital rationing?
describes how limited investment resources are considered as part of investment ranking and selection decisions
if a company has unlimited capital (which is ideal), then all investment alternatives with a positive NPV should be pursued; however, in a more realistic world, a company has extremely limited resources that make its investment choices mutually exclusive
What is the profitability index?
the ratio of the present value of net future cash inflows to the present value of the net initial investment; the ratio will most likely be over 1.0 which means that the present value of the inflows is greater than the present value of the outflows; it measures cash flow return per dollar invested, so the higher the profitability index, the more desirable the project
formula: profitability index = present value of cash flows / cost (present value) of initial investment
What is the hurdle rate of return?
the desired (or minimum) rate of return that is set to evaluate investments or projects; it is used to discount the various cash flows in the NPV method; it may be adjusted (increased) to reflect risk or to compensate for expected inflation; different rates may be used for different time periods
What is a depreciation tax shield?
the tax reduction associated with depreciation; depreciation is not considered in determining cash flows in capital budgeting models, except to the extent that it is a tax shield, since it is deductible for income tax purposes; it is the deprecation times the marginal tax rate
