Reading 35 LOS's Flashcards
LOS 35a: Describe the capital budgeting process, including the typical steps of the process, and distinguish among the various categories of capital projects.
The steps are: 1. Generate Ideas
- Analyze individual proposals (collect info to forecast cash flows, which evaluate feasibility)
- Plan the capital budget
- Monitor and post-auditing (are our forecasts similar to actual performance?) Different categories of capital projects are:
- Replacement projects (doesn’t require a ton of analysis; if a machine breaks down, you must replace it)
- Expansion projects (increase size of current business)
- New products and services
- Regulatory, safety, and environmental
- other projects
LOS 35b: Describe the basic principles of capital budgeting, including cash flow estimation.
Basic principles are: 1. Decisions are based on actual cash flows (only incremental cash flows are relevant, sunk costs are ignored)
- Timing of cash flows is crucial ( time value of money)
- Cash flows are based on opportunity costs ( projects are evaluated compared to their next best alternative)
- Cash flows are analyzed on an after tax basis
- Financing costs are ignored from calculations of operating cash flows ( ignored since they are already considered with the required return. If considered they would be double counted)
- Accounting net income is not used as cash flows for capital budgeting ( because accounting net income is subject to non cash charges like depreciation and financing charges like interest expense)
LOS 35c: Explain how the evaluation and selection of capital projects is affected by mutually exclusive projects, project sequencing, and capital rationing.
1. Independent versus mutually exclusive projects- independent projects cash flows are unrelated where as mutually exclusive projects compete directly with each other for acceptance.
2. Project sequencing- projects can be taken in a certain order, so investing in one project can create opportunity to invest in another project. If the first project is unsuccessful than the second project might not be considered.
3. Unlimited funds vs capital rationing- if a company can raise unlimited capital, it will undertake any project that is profitable. With limited funds, only the most lucrative projects are considered
LOS 35d: Calculate and interpret the results using each of the following methods to evaluate a single capital project: NPV, IRR, payback period, discounted payback period, and profitability index
1. Net Present Value (NPV)
For a project with one investment outflow, which occurs at the beginning of the profect, the net present value is the present value of the future after-tax cash flows minus the investment outlay
- NPV = Σ( After tax Cash flow at time t / (1+r)t) - Outlay
Decision Rules for NPV:
- A project should be undertaken if NPV is greater than 0, as positive NPV projects an increase in shareholder wealth
2. Internal Rate of Return (IRR)
For an investment project with only one investment outlay that is made at inception, IRR is the discount rate that makes the sum of present value of the future after-tax cash flows equal to the initial investment outlay. Alternatively, IRR is the discount rate that equates the sum of the present values of all after-tax cash flows for a project to zero
- Σ (Cash flow at time t / ( 1 + IRR)t ) = Outlay, or
- Σ ( Cash flow at time t / (1 + IRR)t ) - Outlay = 0
Decision Rules for IRR
- A company should invest in a profect if IRR is greater than the required rate of return. When the IRR is greater than the requried return, NPV is postive
3. Payback period
A projects payback period equals the time it takes for the inital investment of the project to be recovered through after-tax cash flows from the project.
Advantages:
- It is simple to calculate and explain
- It can also be used as an indicator of liquidity
Drawbacks:
- It ignores the risk of the project
- It ignores cash flows that occur after the payback period is reached
- It is not a measure of profitability so it cannot be used in isolation to evaluate capital investment projects
4. Discounted Payback Period
The discounted payback period equals the number of years it takes for cumulative discounted cash flows from the poroject to equal the project’s inital investment outlay
Advantage- it accounts for the time value of money and risks associated with the project’s cash flows
Drawback- it ignores cash flows that occur after the payback period is reached
5. Average Accounting Rate of Return (AAR)
The AAR is the ratio of the project’s average net income to its average book value
- AAR = Average net income / average book value
Advantage- it is easy to understand and calculate
Drawbacks:
- It is based on accounting numbers and not cash flows
- It does not account for the time value of money
- It does not differentiate between profitable and unprofitable investments accurately as there are no benchmarks for acceptable AARs
6. Profitability Index
The PI of an investment equals the PV of a project’s future cash flows divide by the initial investment
- PI = (PV of future cash flows)/ Initial Investment= 1 + NPV/ Initial investment
The PI indicates the value we receive in exchange for one unit of currency invested
Decision Rules for PI:
- A company should invest in a project if its PI is greater than 1, indicating NPV is positive
LOS 35e: Explain the NPV profile, compare the NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods
An NPV profile is a graphical illustration of a project’s NPV at different discount rates. NPV profiles are downward sloping because as the cost of capital increases, the NPV of an investment falls
When comparing 2 different project’s NPV profiles, the rate where the NPV of the two projects are teh same is called the crossover rate. This is the cost of capital rate that would make chosing between the two projects indifferent..
If the projects where independent of each other and had positive NPV and IRR, the company could undertake both of them.
If the projects where mutually exclusive, the company can only choose one. In this case if NPV and IRR were to rank the two mutually exclusive projects differently, the project with the higher NPV must be chosen. NPV is a better criterion because of its more realistic reinvestment rate assumptions. IRR assumes that interim cash flows received during the project are reinvested at the IRR, which is sometimes an inappropriate assumption
Problems with the IRR
Multiple Problem IRR
A project has a nonconventional cash flow pattern when the initial outflow is not followed by inflows only. The direction of cash flows changes from positive to negative over the project’s life. This will cause multiple IRRs for a project
No IRR Problem
Sometimes cash flow streams have no IRR
LOS 35f: Describe expected relations among an investment’s NPV, company value, and share price
If a company invests in a positive NPV project, the expected addition to shareholder wealth should lead to an increase in stock price.
However the value of a company is deteremined by valuing its existing investments and adding the expected NPV of its future invesments. The impact of the decision to undertake a particular project on a company’s stock price will depend on how the actual profitability of the investment differes from the expected profitability of a company’s investment
If the profitability of a positive NPV project that the company is about to undertake is below expectations, stock prices may fall. On the other hand, certain capital projects undertaken by the company may signal that there are other potentially lucrative projects to follow.
Capital budgeting processes tell us two things about company management:
- The extent to which management pursues the goal of shareholder wealth maximization
- Management’s effectiveness in pursuit of this goal
