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Chapter 19: Capital Investments
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Terms in this set (40)
capital investment decisions
concerned with the process of planning, setting goals and priorities, arranging financing, and using certain criteria to select long-term assets. Place resources at risk for long periods of time and affect future development
capital budgeting
the process of making capital investment decisions. 2 types: independent projects and mutually exclusive projects
independent projects
projects that, if accepted or rejected, do not affect the cash flows of other projects
mutually exclusive projects
projects that, if accepted, preclude the acceptance of all other competing projects
nondiscounting models and discounting models
what are the 2 major categories of making capital investment decisions?
nondiscounting models
a model for making capital investment decisions; ignores the time value of money
discounting models
a model for making capital investment decisions; explicitly considers the time value of money
payback period
a type of nondiscounting model. it is the time required for a firm to recover its original investment
=original investment/annual cash flow
payback period
problems with this method: ignores the time value of money and it ignores the performance of the investment beyond the payback period.
accounting rate of return (ARR)
nondiscounting model that measures the return on a project in terms of income, as opposed to using a project's cash flow. It ignores the time value of money but it does consider
=average income/original investment
average income (ARR)
this is obtained by adding the income for each year of the project and then dividing this by the total number of years
Can also be approximated by subtracting average depreciation from average cash flow
annual income (ARR)
this is approximated as annual cash flow less annual depreciation expense
Net Present Value (NPV)
one of the two discounting models that explicitly considers the time value of money, and therefore, incorporates the concept of discounting cash inflow and outflows. It is the difference in the present value of the cash inflows and outflows associated with a project
= [Change in CFt/(1+i)¬^t - I] = [Change in CFt x df] - I = P - I
where:
I = the present value of the project's cost (Usually the initial outlay)
CFt = the cash inflow to be received in period t
i = the required rate of return
n = useful life of the project
t = the time period
P = the present value of the project's future cash inflows
Dft = 1/(1+i)^t, the discount factor
required rate of return
the minimum acceptable rate of return. AKA discount rate or hurdler rate; should correspond to the cost of capital
cost of capital
a weighted average of the costs from various sources, where the weight is defined by the relative amount from each source. In theory, this is the correct discount rate, although some firms choose higher discount rates as a way to deal with uncertain nature of future cash flows
positive
if NPV is (positive/negative), it signals 1) the initial investment has been recovered 2) the required rate of return has been recovered and 3) a return in excess of 1) and 2) has been received. Thus, the investment is profitable and acceptable
Internal rate of return (IRR)
the interest rate that sets the present value of a project's cash inflows equal to the present value of the project's cost. It is the interest rate that sets the project's NPV to zero.
=Change in CFt/(1+i)^t
where:
t = years
df
to solve for IRR when annual cash flows are even, let this = I/CF
AKA
=investment/annual cash flow
NPV; IRR
(NPV/IRR) assumes that each cash inflow received is reinvested at the required rate of return, whereas (NPV/IRR) assumes that each cash inflow is reinvested at the computed IRR
IRR; NPV
(NPV/IRR) measures profitability in relative terms. (NPV/IRR) measures profitability in absolute terms - this means it is affected by the size of the investment
Selecting competing projects
The process to do this involves 3 steps: 1) assess the cash flow pattern for each project 2) compute the NPV for each project 3) identifying the project with the greatest NPV
Compute cash flows
2 steps needed to do this: 1) forecasting revenues, expenses, and capital outlays - most challenging step 2) adjusting these gross cash flows for inflation and tax effects
net cash outflows (inflows)
outflows (inflows) adjusted for tax effects. Includes provisions for revenues, operating expenses, depreciation, and relevant tax implications. They are the proper inputs for capital investment decisions
After-tax cash flow Year 0
the net cash outflow (initial out-of-pocket outlay) that is the difference between the initial cost of the project and any cash inflow directly associated with it.
gross cost of project
includes cost of land, equipment (including transportation and installation), taxes on gains from sale of assets, and increases in working capital
cash inflows
these, occurring at the time of acquisition, include tax savings from the sale of assets, cash from the sale of assets, and other tax benefits such as tax credits
depreciation
deducted from revenues in computing taxable income during each year of the asset's life. This is not relevant in Year 0 of a project
After-Tax Operating Cash Flows: Life of the Project
cash inflows can be assessed from the project's income statement. If the project generates revenue, the principal source of cash flows is from operations
annual after-tax cash flows
the sum of the project's after-tax profits and its noncash expenses
=after-tax net income + noncash expenses
=NI + NC
noncash expense
ex: depreciation and losses. These are not cash flows, but they generate cash flows by reducing taxes
Income approach (determining operating cash flows)
= [(1 - tax rate) x revenues] - [(1 - tax rate) x cash expenses] + (tax rate x noncash expenses)
Where:
[(1 - tax rate) x revenues] - this gives the after-tax cash inflows from cash revenues
[(1 - tax rate) x cash expenses] - the after -tax cash outflows from cash operating expense
(tax rate x noncash expenses) - the cash inflow from the tax savings produced by the noncash expenses
personal property
all depreciable business assets other than real estate. Can be in one of six classes. Each class specifies the life of the assets that must be used for figuring depreciation. This life must be used even if actual expected life is different than class life. The class lives are set for purposes of recognizing depreciation and usually will be shorter than actual life
seven-year assets
most equipment, machinery, and office furniture
five-year assets
light trucks, automobiles, and computer equipment
three-year assets
small tools
modified accelerated cost recovery system (MACRS)
used to compute annual depreciation for tax purposes. It is the double-declining-balance method. No consideration of salvage value is required. A half-year convention applies for personal property. This convention assumes that a newly acquired asset is in service for one-half of tis first taxable year of service, regardless of the date that use of the asset actually began
after-tax cash flows: final disposal
at the end of the life of the project, there are two major sources of cash: 1) release of working capital and 2) preparation, removal, and sale of equipment (salvage value effects)
postaudit
a follow-up analysis of a capital project once it is implemented. This should be used to compare actual benefits and costs with estimated benefits and costs. Can reveal the importance of intangible and indirect benefits
salvage value (terminal value)
this has often been ignored in investment decisions but this may not be best practice. A better approach is to deal with uncertainty is to use sensitivity analysis
sensitivity analysis (what-if analysis)
changes the assumptions on which the capital investment analysis relies and assesses the effect on the cash flow pattern.
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