Uses of capital Flashcards
Assumptions of capital allocation:
- decisions are based on CF
- use incremental CF
- exclude sunk costs
- include externalities
- conventional v unconventional CFs - CF are not accounting net income or operating income
- CF are based on opportunity cost
- CF are analyzed on an after-tax basis
- timing of CF is vital
- financial costs are ignored
Decision rule for NPV
- independent projects and mutually exclusive projects
Independent:
- If NPV > 0, accept
- If NPV < 0, reject
Mutually exclusive projects:
- accept the project with the higher and most positive NPV
NPV is:
- the present value of future after tax CF minus the investment outlay
IRR is:
- the discount rate that makes the PV of future CFs equal to the investment outlay
- or, IRR is the discount rate which makes NPV equal to 0
Decision rule for IRR
independent projects and mutually exclusive projects
Independent projects
- If IRR > required rate of return (hurdle rate, cost of capital), accept the project
- If IRR < required rate of return, reject the project
Mutually exclusive projects
- accept the project with the higher IRR (as long as IRR > cost of capital)
If NPV and IRR conflicts occur:
- for single/independent projects with conventional CF, there will be no conflict between NPV and IRR
- for mutually exclusive projects, the two criteria may give conflicting results due to differences in CF patterns and differences in project scale
- if there is a decision conflict, ALWAYS GO WITH NPV
choose NPV because:
- NPV is a direct measure of expected increase in value
- NPV assumes reinvestment of cash at the required rate of return (more realistic); IRR assumes reinvestment of CF at the IRR rate (less realistic)
- IRR is not useful for projects with non-conventional CF
Nominal CF should be discounted at a _____ discount rate, and real CF should be discounted at a _______ rate
discount nominal cf at a nominal discount rate and discount real cf at a real rate.
- nominal CF includes the effects of inflation
- real CFs are adjusted downward to remove the effect of inflation
(1+nominal rate) = (1 + real rate) + (1 + inflation rate)
inflation reduces the value of depreciation tax savings
Higher-than-expected inflation increases the firm’s real taxes and shifts wealth from the firm to the govt
Inflation does not affect all revenues and costs uniformly
Profitability index formula
PI = (PV of future CFs) / initial investment
or, NPV + initial investment / initial investment
Higher PI is better
PI > 1 good
PI < 1 bad
PI = 0 breakeven
Payback period
- is the number of years required to recover the original investment in a project
Use cumulative net cf for each per
ie. -500 outflow initial cost
yr1 +150
yr2 +250
yr3 +400
yr 4 +600
the payback per is between yr 2 and 3; use interpolation to solve
on fin cal: plug in numbers under CF, the NPV and arrow down to “PB”, click cpt = 2.25
Pros
- a good measure of a project’s liquidity and useful to firms with liquidity concerns
Cons
- poor measure of project’s profitability ( does not take into account cf beyond the payback per; so terminal value or terminal value are not considered)
- does not take into account TVM (use the discounted payback per for this)
Discounted payback period
- discounts future CF back to current yr
- use the same steps on fin cal as with payback per, input I, CPT “DPB” = 2.377 years
the discounted PB 2.377 years is longer than the regular PB of 2.25 years
the discounted PB will always be longer
- still does not consider profitability