lecture 4: Project Appraisal Flashcards
why is capital budgeting crucial?
- because it usually requires large investments and it cannot be reversed at a low cost
financing decisions/capital structure?
mixture of long-term debt and equity maintained by a firm
investment decisions/capital budgeting?
process of planning and managing a firm long-term investment
capital budgeting procedures depend on..?
- management’s level in the organisation
- size+complexity or project being evaluated
- size of organisation
what is the typical procedure in capital budgeting?
- generating ideas/searching investment opportunities
- analysing individual proposals and making investing decisions.
for ex: replacement projects, expansion projects, new products and services - implementing
- monitoring and post investment auditing
capital budgeting technique (NPV) decision rules:
- since NVP is added value - only accept projects with positive NVP (>0)
- when choosing between projects - choose one with highest NPV
- in unlikely even NVP turns out to be exactly 0 -> we would be indifferent between taking investment or not taking it
advantages of NVP approach as a capital budgeting technique
- considers time value of money
- accounts for risk associated with the project (i.e. if the risk is high, the discount rate will be high and the benefit of the project decreases)
- considers all expected cash flows incurred during lifetime of the project
- consistent with shareholders’ wealth maximization
disadvantages of NVP approach as a capital budgeting technique
- NVP results are sensitive to estimated cost of capital
- estimating cost of capital of new business is challenging
(but to mitigate these limitations we can use sensitive analysis) - doesn’t take into account initial investment (size) and term of the project
capital budgeting technique:Payback period
-payback period is the length of time it takes to recover our initial investment
- length of time before a project recoups initial investment
decision rules for payback period
- Accept project if payback period is lower or equal to () predetermined maximum cut-off period
- When choosing between projects pick the one with the shorter payback period.
payback period advantages
- Simplicity in calculation and easy to understand
- Not dependent on estimation of cost of capital
- Suitable for small businesses whose sources of funding are limited
- Useful when cash flow projections are of high uncertainty
disadvantages of payback period method
- ignores time value of money
- ignores cash flows after payback period
- biased in favour of short-term projects over long-term projects
- not applicable to appraise project with non-conventional cash flows
- requires an arbitrary cut-off point
- risk to reject project with positive NVP
what is discounted payback period used to do? (capital budgeting techniques)
- Used to address the first drawback of Payback Period, which isdo not consider the time value of money
what does the discounted payback period calculate?
The discount payback period calculates the time period a project will take to recover initialinvestments after considering the time value of money
advantages of discounted payback period method
- Considering the time value of money and the cost of capital (or project’s risk)
- Suitable for small businesses whose sources of funding are limited
- Useful when cash flow projections are of high uncertainty
disadvantages of discounted payback period method
- Results dependent on the estimation of cost of capital.
- Continues to ignore cash flows after payback period.
- Biased in favour of short-term projects over long-term projects.
- Not applicable to appraise project with non-conventional cash flows.
- Requires an arbitrary cut-off point.
- Risk to reject projects with positive NPV
accounting rate of return (capital budgeting technique)
(only project appraisal technique that uses accounting profit)
decision rule for accounting rate of return
- accept project if ARR > target or hurdle rate
- average investment value is the average book value of the investment over its lifetime
advantages of ARR
- easy to calculate
- needed information will be usually available
disadvantages of ARR
- ignores timing of cash flow (time value of money)
- ignores risk associated with long-term investments
- focus on profits rather than cash flows
Internal rate of return (capital budgeting technique) alternative to?
one of the most important alternative capital budgeting techniques to the NVP is the internal rate of return (IRR)
definition of internal rate of return
RR is the rate of the return (discount rate) that makes the NPV of aninvestment zero
IRR decision rules
Accept project if IRR > pre-determined hurdle rate
IRR vs NPV (Individual project with conventional cash flows)
- For an individual project with conventional cash flows, IRR method will yield the sameinvesting decision as the NPV method.
IRR vs NPV (For mutually exclusive project)
When comparing two mutually exclusive projects, investing decisions based on IRR orNPV can lead to conflicting results
–>312. Capital Budgeting Techniques: Internal Rate of Return (Cont.)IRR vs NPV: For mutually exclusive projects Mutually exclusive projects: are projects compete directly with each others. When twoprojects are mutually exclusive, this means that firm can only choose one to invest. When comparing two mutually exclusive projects, investing decisions based on IRR orNPV can lead to conflicting results.Example 8: Suppose that two projects A and B have the following cash flows, NPVs andIRRs. Discount rate is 10%.Whenever the NPV and IRR rank two mutually exclusive projects differently, youshould choose the project based on the NPV.
what are mutually exclusive projects?
Mutually exclusive projects: are projects compete directly with each others. When twoprojects are mutually exclusive, this means that firm can only choose one to invest
advantages of IRR
- Consider the time value of money
- Consider all cash flows expected from the project
- Calculation of IRR does not require estimation of cost of capita
disadvantages of IRR
- implicit assumption in the IRR method is that cash flows from the project can be reinvested at IRR rate. If IRR is too high compared with the cost of capital, this assumption can be unrealistic.
- Ignore the size and term of projects
- No-IRR or multiple-IRR problem for projects non-conventional cash flow pattern
capital rationing?
The investing decisions taking into account the limited budget is called capital rationing
two types of capital rationing?
Soft Rationing (firm’s internal decision): when the firm itself limits the amount of capital that is going to be used for investment decisions in a given time period.
- Hard Rationing: is the limitation on capital that is forced by factors external to the firm.
profitability ratio
if the budget is limited, managers should consider the ratio of present value of project’s cash flow per dollar of initial investment of the proposed projects.
- This ratio is called as Profitability Index
For a single project or independent projects, PI ratio can be used to makeinvesting decision.. if
- If PI>1: Benefit > Cost: Accept the project
- If PI<1: Benefit < Cost: Reject the project
profitability index is mostly used?
for capital rationing
and for single projects it has the same investing decisions as NVP method
if PI method results in conflicting decisions with NVP (when analysing mutual exclusively projects) ->use NPV to rank projects
