S8: NPV, IRR, & Capital Investment Decisions Flashcards
Capital Budgeting
Decisions on the process of analyzing, planning, justifying, & deciding on large capital expenditures
Relevant cash flows
Come as a direct consequence of a project
Stand-alone principle
assumption that evaluation of a project is based on these incremental cash flows alone, treating each project as a “mini-firm” with its own income and expenses
Relevant/incremental costs
Opportunity Cost, NWC, Side effects, Taxes (TONS)
Irrelevant
Financing Costs, Sunk Costs (FS)
Opportunity cost
The most valuable alternative that is given up
NWC
Changes in current assets and liabilities due to a project
Side effects
Erosion: Takes $ away from other projects, Synergy: Boosts $ of other projects
Taxes
Taxes paid on cash flows generated by the project (Usually ~21%)
Financing costs
Debt incurred to pursue a project (mix of debt and equity financing)
Sunk costs
Costs incurred that can’t be undone (land already owned)
Proforma statements
Forecasted future statements
Proforma Income
Sales-Variable costs-Fixed costs-depreciation=EBIT-Taxes (but not interest)=Net Income
OCFp
Operating Cash Flow from project=EBIT+Depreciation-taxes
Proforma Cash Flows
Total CFp= OCFp+-NWC Change+-Capital spending/salvage value
Net Working Capital Recovery
As a project winds down, its inventories, receivables, payables are closed out, freeing up original investment in working capital
Salvage value
Costs of capital spending that can be recovered at the end of the project
Accept or reject?
If CFp>Cost of project then it should be pursued
Depreciation Tax Shield
Tax saving resulting from the depreciation deduction prior to paying income tax, because depreciation expense reduces the amount the firm needs to pay taxes on
5 Methods of Evaluating Investments
Net present value (NPV), Internal Rate of Return (IRR), Payback Period, Discounted Payback Period, Profitability Index (NIPPD)
Net Present Value (NPV)
The difference between an investments present value and its cost (Accept if positive)
Internal Rate of Return (IRR)
The discount rate that makes the NPV of an investment equal to 0 (Accept if greater than Required Rate of Return)
IRR Assumptions
- Required Rate of Return is same as discount rate used in NPV calculations
- Project has conventional cash flows (CFo -, remaining CF+)
- Projects under evaluation are NOT mutually exclusive
Unconventional Cash Flows
Exists when not all cash flows following initial investment are positive -> Use NPV in this case
Mutually Exclusive
Pursuing one project implies that the other can’t be done (have to choose one) -> Us NPV and accept higher NPV
Multiple IRR Problem
Occurs when you try to compare a project with unconventional cash flows, you can get two different “correct” answers for IRR
Payback period
Amount of time required to generate cash sufficient to cover its costs (Accept if payback period is less than time period chosen by firm)
Discounted Payback period
Similar to payback period but discounts cash flows to PV (CF/(1+r)^t))
Profitability Index (AKA Benefit Cost Ratio)
PV of CFp/Initial investment (Go through same steps used for NPV, but instead Leave CF0 as 0 and divide by that as the initial investment instead) (If PI is greater than 1 accept project)
How does $10 move through all three financial statements?
A $10 increase in depreciation reduces net income by $7 (IS), increases cash flow by $3 due to tax savings, and decreases assets by $10 (BS), balanced by a $7 reduction in retained earnings and a $3 increase in cash (SCF).
