time value of money - making investment decisions Flashcards
what is capital budgeting.?
evaluation process used by firms in deciding what project to undertake
Identification of Relevant Cash Flows
what is the incremental net cash flow of a project?
difference between the firm’s cash flows if the project is undertaken and the firm’s cash flows if the project is not undertaken.
Identification of Relevant Cash Flows
When considering an investment project, it is important to note we are only concerned
with the incremental cash flows associated with the project.
Identification of Relevant Cash Flows
Straight Line Depreciation Example:
If an asset costs $20,000, has an estimated salvage value of $5,000 and a useful life of 5 years, the annual straight-line depreciation charge is calculated as:
straight line depreciation formula
identification of relevant cash flows
4 points in relation to the depreciation charge:
- Sales tax, delivery charges and installation are treated as being part of the initial cost of equipment. Therefore, they are added to the cost of the asset for the purpose of calculating depreciation;
- In some jurisdictions it is possible to depreciate an asset down to zero even if it has an estimated salvage value. However, in this course, if the equipment has an estimated salvage value at the end of its useful life, the asset is depreciated down to this value
- The asset could be sold for more or less than its depreciated (or book) value. I_f an asset is sold for a price greater than its depreciated value, the_ excess is a taxable gain. Conversely, if the asset is sold for a price less than the depreciated value, the difference is an allowable deduction for tax purposes.
- Costs associated with old equipment, including removal expenses, are not regarded as part of the cost of the new machinery and therefore are expensed immediately (ie at time 0).
net present value (NPV) of a project
equal to the present value of all future incremental cash flows associated with it less its initial cost, where cash flows are discounted to their present value using the rate of return required on the project, rp
The NPV Decision Rule
determining whether to accept or reject a particular project using NPV analysis, we apply the NPV decision rule. This rule can be summarized as follows:
–Accept a project if its NPV>0 ( increase wealth of firm);
–Reject a project if its NPV –Indifferent to a project if its NPV=0. (does not add or reduce firm’s value)
Assuming that the required rate of return for this project is 10% per annum, calculate the present value of all cash flows, sum these values and apply the NPV rule to conclude whether it is a worthwhile project:
Comparing Mutually Exclusive Projects
. Comparing Projects with Different Lives
calculate
Given these results, the firm should accept Machine A. This is because using a sequence of Machine As will add the equivalent of $804.23 of NPV to the firm each year, while Machine B would only add $791.39 to the firm annually.
. Comparing Projects with Different Lives
what is the annual equivalent cash flow for a project
. Comparing Projects with Different Lives
can we compare the NPV figures?
While Machine B has the highest NPV, it also has a useful life of 5 years instead of three years. Therefore, the NPV figures are not comparable as they have been calculated based on different lives. We need to restate the NPVs of the two alternatives in a way that will allow direct comparison. One way to do this is to compare the annual equivalent cash flows of the two projects.
according to the NPV decision rule,
select projects with postive NPV as these projects increase wealth (value of firm increases –> investors are wealthier)
PV benefits > PV costs
