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Finance: Capital Budgeting
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Definitions from RWJ: Chapters 9, 10, 11, and 24 and Curtis Lecture Notes on Capital Budgeting.
Terms in this set (37)
Net Present Value
The difference between and investment's market value and its cost.
An investment should be accepted if the Net Present Value is positive and rejected if it is negative.
Advantages:
1. Incorporates the timing of cash flows.
2. gives the theoretically correct/reject specification.
Discounted Cash Flow Valuation
Advantages:
1. Takes into account time value of money.
Disadvantages:
1. Still ignores cash flows after payback.
Packback Period
The amount of time required for an investment to generate cash flows sufficient to recover its initial cost.
Advantages:
1. Easy to understand
2. Can serve as a control; large payback can act as a warning signal.
Disadvantages:
1. Ignores the timing of cash flows
2. Ignores the cash flows after the payback period.
Average Accounting Return
Is an investment's average income net income divided by its average book value. Some measure of accounting profit/some measure of average accounting value.
Disadvantages:
1. Ignores time value of money
2. Ratio of two accounting numbers, not comparable to returns offered.
3. Subjectivity in cutoff.
Internal Rate of Return
The discount rate that makes the NPV of an investment zero.
Based on the IRR rule, an investment is acceptable if the IRR exceeds the required return.
Advantages:
1. Incorporates the timing of cash flows.
2. Will give the correct/accept decision for a single conventional investment.
Disadvantages:
1. Requires the choice of a hurdle rate.
2. May have multiple rates of return.
3. Not acceptable to use for mutually exclusive investments.
Net Present Value Profile
Is a graphical representation of the relationship between an investment's NPV and various discount rates.
Multiple Rates of Return
The possibility that more than one discount will make the NPV of an investment zero. This occurs when there is a negative cash flow at some point in the future, after both the initial negative cash flow and one or more positive cash flow. In this case, IRR breaks down completely, but NPV still works fine.
Mutually Exclusive Investment Decisions
Situations in which taking one investment prevents the taking on another. If two investments are mutually exclusive we should take the one with the higher Net Present Value (not always the one with the higher return).
Profitability Index
The present value of the an investment's future cash flows divided by its initial cost; also known as the benefit-cost ratio. PI will be greater than 1 for positive NPV and less than 1 for negative NPV projects.
Incremental cash flows
Any and all changes in the firm's future cash flows that are direct consequences of taking the project.
Stand-Alone Principle
The assumption that evaluation of a project may be based on the project's incremental cash flows.
Sunk Costs
Costs that are already incurred and cannot be removed and therefore should not be considered in an investment decision. They are not incremental and not relevant!
Opportunity Cost
The the most valuable alternative that is given up if a particular investment is undertaken. It should be taken into account in evaluating the project and is equal to the next most profitable use of the resource.
Erosion
The cash flow of a new project that come at the expense of a firm's existing projects. Cash flows from the new line should be adjusted downward to reflect the lost profits to other lines.
Net Working Capital
Projects usually require the firm invest in net working. This is a use of funds. If a project is terminated and the inventories are liquidated, accounts receivables are collected on, and accounts payable are paid, then net working capital is said to be recaptured. This is a source of cash as long as cash generated from inventory sales and collection of accounts receivable is more than cash paid to discharge accounts payable.
Financing Costs
We do NOT include interest paid or any other financing costs such as dividends or principal repaid.
Forecasting Risk
The possibility that errors in projected cash flows will lead to incorrect decisions; also known as estimation risk.
Scenario Analysis
The process of estimating the expected value of a portfolio after a given period of time, assuming specific changes in the values of the portfolio's securities or key factors that would affect security values, such as changes in the interest rate.
Scenario analysis commonly focuses on estimating what a portfolio's value would decrease to if an unfavorable event, or the "worst-case scenario", were realized. Scenario analysis involves computing different reinvestment rates for expected returns that are reinvested during the investment horizon.
Read more:
Sensitivity Analysis
The investigation of what happens to NPV when only one variable is changed. It is useful in pinpointing the areas where forecasting risk is especially severe.
Simulation Analysis
A combination of scenario and sensitivity analysis. In order to let both the variables and the values change, we must consider a number of scenarios and almost certainly require compute assistance.
Break-Even Analysis
A common tool to analyze the relationship between sales volume and profitability.
Variable Costs
Costs that change as output changes
Fixed Costs
Are costs that do not change when the quantity of output changes during a particular time period.
Accounting Break - Even
The sales level that results in zero project net income. We do not consider any interest expense in calculating net income or cash flow from the project, but we do include depreciation, even thought it is not a cash outflow.
Cash break- even point
The sales level that results in zero operating cash flow. Projects with net accounting income of zero can still have positive cash flow.
Financial break - even
The sales level that results in zero NPV. Most interesting case to financial manager. First, we determine what OCP must be for NPV to be zero; then we use this amount to determine sales volume.
Operating Leverage
The degree to which a firm or project relies on fixed costs. Heavy investments in plant and equipment yield a high degree of operating leverage.
Degree of Operating Leverage
The percentage change in OCP relative to percentage change in quantity sold. Operating leverage declines as output rises.
Capital Rationing
The situation that exists if a firm has positive NPV projects but cannot find the necessary financing.
Soft Rationing
The situation that occurs when units in a business are allocated a certain amount of financing for capital budgeting. Ongoing soft rationing could mean constantly bypassing positive NPV investments. Corporation as a whole isn't short of capital; more can be raised on ordinary terms if management so desires.
Hard Rationing
The situation that occurs when a business cannot raise financing for a project under circumstances. Doesn't often occur for large, healthy corporations. Occurs when company aces financial troubles or when company cannot raise funds without violating preexisting contractual agreements.
Real Options
Options that involve real assets as opposed to financial assets such as shares of stock. Essentially all proposed projects are real options.
Investment Timing Decision
The evaluation of the optimal time to begin a project. Option to wait can be valuable. Just because a project has a negative NPV today doesn't mean it will have a negative NPV in the future.
Managerial Options
Opportunities that managers can exploit if certain things happen in the future. Deals with modifications to project after it is launched.
Contingency Planning
Taking into account the managerial options implicit in a project:
1. Option to Expand: Can we expand our large NPV project to create an even large NPV?
2. Option to Abandon: We underestimate NPV by assuming that the project must last for some fixed number of years.
3. Option to Suspend: Temporary shutdown, permanent scale-back, etc.
Strategic Options
Options for future, related business products or strategies. Testing the water; pilot studies, R&D.
Sources of Positive NPV Projects.
1. Perhaps the largest source of positive NPVs are monopoly rents - profits above those necessary to keep resource employed in an endeavor that accrue as the result of being the only able or allowed to do something. Such rents quickly dissipate in a competitive market.
2. Alan Shapiro suggests looking for:
a. Economies of Scale
b. Product Differentiation
c. Cost advantages
d. Access to distribution channels
e. Favorable government policy
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