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fin 314 ch 9- ch 11
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Terms in this set (47)
what is the defintion of Net Present Value - The basic idea
The difference between the market value of a project and its cost
what is NPV?
The PV of future cash flows is not NPV;
rather, NPV is the amount remaining after offsetting the PV of future cash flows with the initial cost.
what is the goal of NPV?
Since our goal is to increase owner wealth,
NPV is a direct measure of how well this project will meet our goal.
Do you accept the NPV if its postive?
If the NPV is positive, accept the project
payback period
the amount of time required for an investment to generate cash flows sufficient to recover its initial costs.
Payback period -
- length of time until the accumulated cash flows equal or exceed the original investment.
Decision Rule payback period
Decision Rule - Accept if the payback period is less than some preset limit
Discounted Payback Period
It is the length of time a firm must wait to recoup, in present value terms, the money it has invested in a project.
Discounted Payback Period
Decision Rule:
Decision Rule: Accept the project if it pays back on a discounted basis within the specified time
Average Accounting Return
-Average net income / average book value
-Note that the average book value depends on how the asset is depreciated.
-Need to have a target cutoff rate
Average Accounting Return
Decision Rule:
Decision Rule: Accept the project if the AAR is greater than a preset rate
Computing AAR
AAR = average net income / average book value
The Internal Rate of Return
Definition: IRR is the return that makes the NPV = 0
The Internal Rate of Return
Decision Rule:
Decision Rule: Accept the project if the IRR is greater than the required return.
IRR and Nonconventional Cash Flows
When the cash flows change sign more than once, there is more than one IRR
If you have more than one IRR, which one do you use to make your decision?
IRR and Mutually Exclusive Projects
Mutually exclusive projects
If you choose one, you can't choose the other
Example: You can choose to attend graduate school at either Harvard or Stanford, but not both
Intuitively, you would use the following decision rules:
NPV - choose the project with the higher NPV
IRR - choose the project with the higher IRR
Profitability Index
The profitability index is the present value of an investment's future cash flows divided by the initial cost of the investment
If there are additional outflows after year 0, then the profitability index = present value of inflows / present value of outflows.
If a project has a positive NPV, then the PI will be greater than 1.
Capital Budgeting In Practice
We should consider several investment criteria when making decisions
NPV and IRR are the most commonly used primary investment criteria
Payback is a commonly used secondary investment criteria
Asking the Right Question
Relevant Cash Flows
You should always ask yourself "Will this cash flow occur ONLY if we accept the project?"
If the answer is "yes," it should be included in the analysis because it is incremental
If the answer is "no," it should not be included in the analysis because it will occur anyway
If the answer is "part of it," then we should include the part that occurs because of the project
incremental cash flows
cash flows if it accepts a project and the firm's future cash flows if it does not accept the project
The stand-alone principle
allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
Sunk costs
Sunk costs - costs that have accrued in the past
Opportunity costs
Opportunity costs - costs of lost options
Common Types of Cash Flows
Side effects
Positive side effects - benefits to other projects
Negative side effects - costs to other projects
Changes in net working capital
Financing costs
Taxes
Pro Forma Statements and Cash Flow
Capital budgeting relies heavily on pro forma accounting statements, particularly income statements
Why do we have to consider changes in NWC separately?
Why do we have to consider changes in NWC separately?
GAAP requires that sales be recorded on the income statement when made, not when cash is received
GAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers yet
Finally, we have to buy inventory to support sales, although we haven't collected cash yet
Depreciation tax shield
The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes
Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes
Depreciation tax shield = D × T
D = depreciation expense
T = marginal tax rate
Computing Depreciation
Straight-line depreciation
Straight-line depreciation
D = (Initial cost - salvage) / number of years
Very few assets are depreciated straight-line for tax purposes
MACRS
Need to know which asset class is appropriate for tax purposes
Multiply percentage given in table by the initial cost
Depreciate to zero
Mid-year convention
After-tax Salvage
If the salvage value is different from the book value of the asset, then there is a tax effect
Book value = initial cost - accumulated depreciation
After-tax salvage = salvage - T*(salvage - book value)
After-tax salvage same
Salvage value is the value a company or individual receives, or expects to receive from the sale of an asset at the end of the asset's useful life.
Forecasting risk -
the possibility that incorrect decisions will be made due to erroneous cash flow projections
Sensitivity Analysis
An analysis of the change in a project's NPV when a single variable is changed
This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV
The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation
Simulation Analysis
An analysis which combines scenario analysis with sensitivity analysis
The output is a probability distribution for NPV with an estimate of the probability of obtaining a positive net present value
The simulation only works as well as the information that is entered, and very bad decisions can be made if care is not taken to analyze the interaction between variables
erosion
cash flows of a new project that come at the expense of a firm's existing projects new project revenues are gained at the expense of existing product
Making a Decision
Paralysis of Analysis"
You have to make a decision
If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project
If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project
Break-Even Analysis
Common tool for analyzing the relationship between sales volume and profitability
There are three common break-even measures
Accounting break-even: sales volume at which NI = 0
Cash break-even: sales volume at which OCF = 0
Financial break-even: sales volume at which NPV = 0
Example: Costs
Total variable costs = quantity * cost per unit
vary directly with sales
VC = Q * v
Fixed costs are constant over the short-run regardless of the quantity of output produced.
Total costs = fixed + variable = FC + (Q * v)
Example:
Your firm pays $3,000 per month in fixed costs. You also pay $15 per unit to produce your product.
What is your total cost if you produce 1,000 units?
What if you produce 5,000 units?
Average vs. Marginal Cost
Average Cost
TC / # of units
Will decrease as # of units increases
Marginal Cost
The cost to produce one more unit
Same as variable cost per unit
The quantity that leads to a zero net income
NI = (Sales - VC - FC - D)(1 - T) = 0
Accounting Break-Even
Q = (FC + D) / (P - v)
P = price per unit
v = variable cost per unit
Q = # of units or quantity
FC = fixed costs
D = depreciation
T = tax rate
Using Accounting Break-Even
Accounting break-even is often used as an early stage screening number
If a project cannot break-even on an accounting basis, then it is not going to be a worthwhile project
Accounting break-even gives managers an indication of how a project will impact accounting profit
Sales Volume and Operating Cash Flow
What is the operating cash flow at the accounting break-even point (ignoring taxes)?
OCF = EBIT + D - T
OCF = (S - VC - FC - D) + D - T
OCF = (P
Q) - (v
Q) - FC
What is the cash break-even quantity (ignoring taxes)?
OCF = net income + depreciation
OCF = (S - VC - FC - D) + D
OCF = (P
Q) - (v
Q) - FC
OCF = Q(p-v) - FC
Q = (OCF + FC) / (P - v)
Three Types of Break-Even Analysis
Accounting Break-even
Where NI = 0
Q = (FC + D)/(P - v)
Cash Break-even
Where OCF = 0
Q = (FC + OCF)/(P - v); (ignoring taxes)
Financial Break-even
Where NPV = 0
Cash BE < Accounting BE < Financial BE
Operating Leverage
Operating leverage is the relationship between sales and operating cash flow
Degree of operating leverage measures this relationship
The percentage change in OCF relative to a percentage change in quantity.
Capital Rationing
Capital rationing occurs when a firm or division has limited resources
Soft rationing - the limited resources are temporary, often self-imposed
Hard rationing - capital will never be available for this project
The profitability index is a useful tool when a manager is faced with soft rationing
Fixed costs
are constant over the short-run regardless of the quantity of output produced.
Variable costs
are those costs that vary depending on a company's production volume; they rise as production increases and fall as production decreases. Variable costs differ from fixed costs such as rent, advertising, insurance and office supplies, which tend to remain the same regardless of production output.
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