Module 43b: Capital Budgeting Flashcards
Capital budgeting
is a technique to evaluate and control long-term investments
there are 6 stages:
- identification stage
- search stage
- information-acquisition stage
- selection stage
- financing stage
- implementation and control stage
identification stage of capital budgeting
management determines the type of capital projects that are necessary to achieve managements objectives and strategies
search stage of capital budgeting
management attempts to identify alternative capital investments that will achieve managements objectives (which project?)
information-acquisition stage of capital budgeting
management attempts to revaluate the various investments in terms of their costs and benefits
selection stage of capital budgeting
management chooses the projects that best meet the criteria established
financing stage of capital budgeting
management decides on the best source of funding for the project
implementation and control stage of capital budgeting
management undertakes the project and monitors the performance of the investment
capital budgeting alternatives are usually evaluated using
discounted cash flow techniques:
1. PV of future cash returns from the investment
the objective is to identify the most profitable or best investment alternative
cash returns of capital project alternatives come in two forms
- return can be revenue
- return can be cost savings (e.g. cash outflows for labor are not made anymore because a new machine is more efficient)
conceptually the results of both types of projects are the same
the entity ends up with more cash by making the initial capital investment
sunk, past, or unavoidable costs
are committed costs that are not avoidable and are therefore irrelevant to the decision process
avoidable costs
are costs that will continue to be incurred if a department or product is terminated
committed costs
arise from a company’s basic commitment to open its doors and engage in business (depreciation, property taxes, management salaries)
discretionary costs
are fixed costs whose level is set by current management decisions (advertising, research and development)
relevant costs
are the future costs that will change as a result of a specific decision
differential (incremental) costs
is the difference in cost between two alternatives
opportunity cost
is the maximum income or savings (benefit) foregone by rejecting an alternative
outlay (out-of-pocket) cost
is the cash disbursement associated with a specific project
**the choice among alternative investing decisions can be made on the basis of several capital budgeting models:
- payback or discontinued payback
- accounting rate of return
- net present value
- excess present value index
- internal (time-adjusted) rate of return
the payback method
evaluates investments on the length of time until recoup (return) of the investment
= investment/ annual cash inflow
annual cash inflow= subtract out depreciation, taxes to give you the net income after taxes. NIAT is calculated on an accrual basis, so you add depreciation back in to get annual cash inflow on a cash basis
payback method advantages and disadvantages
advantages: defacto measurement of risk because the sooner you pay back the investment, the less risky it is
its easy and intuitive
disadvantages: does not involve the time value of money; has little connection to maximization or shareholder value; completely ignores everything after the point for which you pay the investment off (example: an investment that takes 3 years to pay off and gives you cash flows for 6 years is NOT better than an investment that takes you 5 years to pay off but gives you cash flows for 20 years)
discounted payback method
essentially the same method as the payback method except that in calculating the payback period, cash flows are first discounted to their present value
this is only a minor improvement over the conventional payback method
it STILL ignores any cash flows after the cutoff period and therefore does not consider total project profitability
Accounting rate of return (ARR) method
computes an approximate rate of return which ignores the time value of money
=Annual net income /
average (or initial) investment
looked at as a micro level (on one project) compared to the rate of return, which looks at like a whole division or the entire company
Accounting rate or return method advantages and disadvantages
advantages: it is simple and intuitive because net income and investment are meansures used throughout business; it is also the measure often used to evaluate management ; the technique corresponds to the measure that is often used to evaluate performance
disadvantages:
1. the results are affected by the depreciation method (and every decision you make on the accrual basis of accounting affects the results)
2. ARR makes no adjustment for project risk
3. ARR makes no adjustment for the time value of money
net present value method
is a discounted cash flow method which calculates the present value of the future cash flows of a project and compares this with the investment outlay required to implement the project
=PV of future cash flows
- required investment
excess present value (profitability) index
computes the ratio of the present value of the cash inflows to the initial cost of the project
it is used to implement the net present value method when there is a limit on funds available for capital investments
assuming other factors are equal, this is accomplished by allocating funds to those projects with the highest excess present value indexes
use the minimum required rate of return
= (present value of future net cash inflows (benefits) / initial investment) x 100
if the index is equal to or greater than 100%, the project will generate a return equal to or greater than the required rate of return
net present value method advanages
the most widely accepted methods of evaluating a captial expenditure because:
- presents results in dollars which are easily understood
- adjusts for the time value of money
- considers the total profitability of the project
- provides a straightforward method of controlling the risk of competing projects- higher risk cash flows (projects) can be discounted at a higher interest rate (you can completely control risk with how you choose the discount rate)
- provides a direct estimate of the change in shareholder wealth resulting from undertaking a project (the higher the NPV, the higher the wealth that goes to shareholder)
net present value method limitations
- may not be considered as simple or intuitive as some other methods
- does not take into account the management flexibility with respect to a project- management may be able to adjust the amount invested after the first year or two depending on the actual returns
an annuity*
MUST BE EQUAL PAYMENTS!!!
it a question gives you present value information for an annuity but the payments arent equal, you have to derive the present value table of $1 from the annuity values.
remember: the difference between each annuity is the next period in a regular present value table
example: multiple choice 45 page 225
Internal rate of return (IRR) method
is another discounted cash flow method
it determines the rate of discount at which the present value of the future cash flows will excactly equal the investment outlay (i.e. a rate that results in a NPV of zero)
calculated by setting the investment today equal to the discounted value of future cash flows
the discounting factor (rate of return) is the unknown
relationship between NPV and IRR
direct relationship
NPV > 0 IRR > discount rate (req. rt of return)
NPV = 0 IRR = Discount rate
NPV < 0 IRR < Discount rate
hurdle rate
the firms minimum acceptable rate of return for the project
if the firm has sufficient funds to undertake all projects, the calculated internal rate of return on a project is compared to a prespecified hurdle rate
the hurdle rate is determined based on the market rate of return for projects with similar levels of risk
IRR advantages
- adjusts for the time value of money
- the hurdle rate is based on market interest rates for similar investments
- the results tend to be a little more intuitive than the results of the net present value method
IRR disadvantages
- depending on the cash flow pattern there may be no unique internal rate of return for a particular project- there may be multiple returns depending on the assumptions used
- occasionally, there may be no real discount rate that equals the project’s NPV to zero
- the technique also has limitations even when evaluating mutually exclusive investments (next)
mutually exclusive projects
until now, we have assumed that management can invest in any project that meets the particular criteria being used
however, at times management must decide on one of several projects that are all acceptable (or the best project)
capital rationing
choosing the best project out of several projects that are all acceptable
this is typically the one that has the largest NPV
net present value profile
to decide on the best investment, management must examine the characteristics of each
one way of summarizing the characteristics is through the use of the NPV profile
the profile allows us to portray the net present value of projects at different discount rates
cash flows at the end of the expected life of the project
- terminal disposal price of any long term tangible or intangible assets. if the tax basis (initial cost- tax depreciation taken) is expected to be different from the disposal price, the tax gain or loss will generate a tax inflow or outflow
- recovery of any working capital investment- this investment will be recovered at the end of the project by liquidation of inventories, accounts receivable, etc. there are generally no tax implications of this recovery because it is assumed that the cash received will be equal to the book value (tax basis) of the working capital
considering risk in capital budgeting
risk as applied to capital budgeting is defined in terms of variability of the possible outcomes from a given invesment
projected cash flows are NOT KNOWN with certainty
probability analysis
one way to include risk in the capital budgeting analysis is to assign probabilities to possible outcomes
all you need to know is that all probabilities have to add up to 100%
generally the larger the standard deviation…
the greater the risk
to eliminate the size difficulty analysts have developed a performance measure (coefficient of variation)
which is simply the standard deviation divided by the expected value of the investment (relative risk)
risk adjusted discounted rate
different interest rates to calculate different cash flows
a popular approach to adjust for risk involves using different discount rates for proposals with different levels of risk
using this technique, management is applying risk-adjusted discount rates
time adjusted discount rates
the farther you go into the future, the higher interest rate you use to calculate cash flows
lease versus buy
in capital budgeting, it is important to evaluate whether it may be more advantageous to lease the asset rather than purchase it
in making a lease versus buy decision, management will often compare the two alternatives using discounted cash flow
depending on the circumstances, leasing may provide an attractive alternative for a number of reasons
leasing advantages
- there may be tax advantages to structuring the acquisition as a lease
- leasing may require less initial investment
- leasing will require less formal borrowing which may be restricted by loan covenant tied to the companys other debt
- certain leases do not have to be capitalized and therefore will not rewuire recognition of debt on the companies balance sheet
portfolio risk
theoretically, management should evaluate all possible combinations of investment projects to determine which set will provide the best trade-off between risk and return
this process is very similar to an investor’s process of putting together a portfolio of financial investments
risk preference function
conceptually, the sets of portfolios that meet management’s trade-off between risk and return can be visualized as falling on an indifference curve or RISK PREFERENCE FUNCTION
a risk preference function illustrates the efficient frontier for portfolio investments
any risk that falls on the line is an efficient portfolio; it means managements objectives with respect to the trade-off between risk and return
any portfolio that falls to the right is not efficient
graph on page 218
coefficient of correlation
a measure that is used to express the extent of correlation between a set of investments
this measure takes a value from +1 to -1
sign. risk some risk little risk
reduction reduction reduction
-1 -0.5 0 +0.5 +1
