(LT) Capital budgeting (1) Flashcards
What is the difference between a standalone and mutually exclusive project ?
Stand-alone: Is Project A better than doing nothing?
Mutually exclusive: Is Project A better than Project B?
What is NPV and what is decision rule?
NPV>0
What are 2 advantages of NPV?
1) Adv: Time value of money
2) Convenient: present values are additive
NPV(A+B) = NPV(A)+NPV(B)
What are the alternativative valuation methods that compete with NPV for capital budegting? (3)
1) Book rate of return
2) Payback period
3) Internal rate of return
What is the Accounting rate of return and decision rule?
what are 2 disadv of this?
Accept if high enough.
Disadv: Time value of money ignored
Disad: The components reflect tax and accounting figures and are not
market values or cash flows
What is payback period, decision rule and why is method flawed?
Payback Period: the number of years it takes before the cumulative
forecasted cash flows of a project equals the initial outlay.
Decision rule: Accept projects that “payback” within a desired time frame
Ignores all cash-flows after the payback period
Ignores time value of money and risk,
Work out the payback period for this example?
What is the IRR?
Its the discount rate that would make NPV = 0.
When comparing IRR and NPV what is the rule about accepting projects?
What is another word for Opportunity cost of capital?
You accept the project if opportunity cost of capital < IRR.
You reject the project if opportunity cost of capital > IRR.
Hurdle rate.
What are pitfalls of IRR?
1) Borrowing and Lending
2) mutually exclusive projects
What is the pitfall of mutually exclusive projects?
So usually the decision rule when picking between 2 projects is that you pick the one with the highest IRR, however you don’t compare Apples to Oranges ( the projects being compared should be in the same risk-class ( same cost of capital). ( so differences in scale)
What is the pitfall of Lending vs Borrowing for IRR? Use this as an example?
So Project A you are lending and Project B you are borrowing money. So the rules are reversed when borrowing money so if IRR < cost of capital then you accept.
Whats the problem here?
The following two projects illustrate the problem. IRR picks E, but F
is better at the cost of capital.
How can the issues that arise from using the IRR valuation method for mutually exclusive projects ( cannot occur together) be remedied?
What does mutually exclusive mean?
Event cannot occur at the same time e.g coin toss when you throw a coin you can get either heads or tails but not both.
How can the issues that arise from using the IRR valuation method for mutually exclusive projects be remedied?
Calculating the IRR of the incremental cashflows that would result from taking one project instead of the other provides a potential remedy when comparing mutually exclusive projects
KEY: MAKE THE INCREMENTAL CASH FLOWS LOOK LIKE AN INVESTMENT PROJECT (-ve cash flow initially)
Incremental Cash flow of investing in Project A instead of B is =A-B at each time period
Incremental Cash flow of investing in Project B instead of A is =B-A at each time period.
Consider 2 mutually exclusive projects and you can only pick one( cannot pick both at same time), calculate the incremental cashflows that would result from taking one project instead of the other to remedy mutually exclusive projects?
Lets say you want to invest in A rather than B.
The IRR is greater than the OCOC so accept.
When talking about NPV here what will we assume?
That the firm is an all equity firm.( unlevered)
What does Free cash flows mean?
Are the left over cash flows to distribute to investors after all operating expenses and capital expenditure have been made, assuming the project is equally financed. ( it dozen’t look at a firms financing decisions but rather operating decisions).
So we want to know the extra( incremental cash flows that will result from taking a project.)
What are the FCF rules?
Include opportunity costs
Ignore sunk costs
Include all externalities ( e.g. if cannalibisation happens, still include e.g. if coca cola was to release a new flavour of Coke O and meant loss in sales in other flavour of coke, then the loss in sales on other is an investment cash flow from our project. )
What is the FCF formula?
What is this?
Depreciation tax shield reflects the Tax Savings from the Depreciation Expense deduction
What is CAPEX and why is it negative?
Capital expenditures( e.g. investments in PPE)
Since investments in Plant, Property & Equipment (e.g. machinery)
generally cannot be claimed as an expense for accounting purposes, they
do not appear on the income statement directly.
But investments cost money!!
This expenditure will lower available FCFs, hence we subtract capital
expenditures/investments in the FCF calculation
What is salvage value?
The salvage value of an asset is based on what a company expects to receive in exchange for selling the asset at the end of its useful life.
If the salvage value is greater than the book value of an asset, what must we have?
What sign is Salvage value?
We have a gain, which we have to pay tax on. ( sales price - book value)
Its positive so you had to the FCF.
What is the formula for Book value and Gain on sale?
Book Value = Initial Investment − Accumulated Depreciation
What is net working capital and what are the implications of the the sign?
Non cash Current Assets ( we don’t include cash) - Non interest bearing CL( e.g any long term debt would not be included as it has interest bearing on it) .
a positive change in net working capital implies reduced cash flow for a company, whereas a negative change in net working capital means the opposite, an increase in cash flow.
TBH
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WE ARE NOW LOOKING AT INFLATION :
Recall the relationship between the nominal interest rate, the real interest rate and the expected inflation rate, what is the formula and what do we have to remember.
First of find the NPV using nominal figures?
As the real values take into account inflation we have to reverse this to find nominal amounts, then discount via Nominal interest rate to find NPV.
Find the NPV using real values.
What are 2 NPV applications?
Profitability index
Equivalent Annual Cash Flow ( EAC)
In a perfect world a company would accept all positive NPV projects that comes its way but in reality we have constraints e.g. budget constraints, hence we need to a tool for us to help understand what to accept and reject?
Profitability index
What is our decision rule for Profitability Index?
Choose the combination of projects with the highest weighted-average Profitability index.
Workout the profitability index for each project?
Remember the decision rule?
What happens with any unused cash?
We choose the one with the highest weighted average Profitability index.
Any unused cash has a PI = 0.
What is Equivalent annual cash flows and what is Equivalent annual cost?
Deals with projects that have unequal lives. You are spreading the NPV of a project into an annuity( a series of pv of cash flows each period)
Equivalent annual costs = When the CFs are cost.
What is the formula for EAC?
As you can see 1 machine has a maturity of 3 years and the other 2, so if we were looking at this purely on a PV basis what machine would we pick, if we want to pick the machine which it cost lower to maintain, as you replace your machine every 2/3 years.
what is the problem of this? What is the key point here?
We would pick Machine B, as it has lower NPV( but the problem here is that we don’t know if its generally low cost or that it has a shorter maturity
REMEMBER WE ARE GOING TO REPLACE THESE MACHINES HENCE B WOULD ACTUALLY BE WRONG.
Now calculate the EAC of Machine A and B and decide which one you would pick?
What have we assumed?
On the basis of EAC machine A is cheaper to run not B.
We have assumed that in the future the machines will be the same price and will not change in the future.
