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FIN 3309 End of Semester Content
Terms in this set (65)
A tool to decide what long-term projects to invest in
Long term money raised by the firm
Capital budgeting could take the form of...
-additional funding for existing projects
-investment in a new project
The capital budgeting process includes
-evaluating the project
-estimate cash flows expected from project
-value the future cash flows
The difference between the cash that came into the firm and the cash that was paid out during a period
Which cash flows are relevant to the capital budgeting process?
INCREMENTAL cash flows. Only those that are a direct consequence of the project.
The Stand Alone Principle
If we focus only on the change in firm cash flows resulting from the project in question, we are treating the project like a mini-firm. Those cash flows "stand alone."
-Not a cash flow of the project itself, but a CF in another area directly caused by the project
-Erosion or cannibalization: decrease in other line due to new product (release of new iPhone decreased sales of old iPhones)
-Could work other way too: advertising for a new product could draw more traffic and sales in other lines
Net working capital requirements
-The firm invests (sets aside) part of its working capital in the new project, buys inventory, increases receivables by selling on credit, etc.
-Whatever is invested at the beginning of the project is recaptured at the end of the project
-A cost related to the project but that the firm has or will incur even if the project is not undertaken
-Example: hiring a consultant to determine whether a project is viable
-Giving up the opportunity to use an already-owned asset for another purpose when the firm chooses to use it for the proposed project
-Example: using a building already owned for a new project
Only ___________ that are truly incremental should be incorporated.
OVERHEAD COSTS. Only allocate to the project if it is related to the project.
Normally overhead is not charged unless...
there is a SPECIFIC cost
NOT counted as operational cash flows, are part of cost of capital
Basic characteristics of relevant project cash flows
- Cash flows (not accounting flows)
- Incremental cash flows (what changes)
- After-tax cash flows (including result of any changes in the tax rate)
Basic principles to follow to accurately estimate after-tax operating cash flows
-IGNORE all sunk costs
-IGNORE all financing costs (interest expense, loan closing fees, etc)
-INCLUDE opportunity costs (what is being given up)
-INCLUDE changes in working capital requirements that are a result of the project
-INCLUDE incidental (side effects) cash inflows or outflows
-INCLUDE only those overhead costs that are incremental
-INCLUDE any tax savings (benefits) or expense that result from new project
Basic process for calculating capital budgeting cash flows
1) Find the Initial Cost/Investment/Outlay
2) Find Operating Cash Flow (OCF)
3) Find Terminal Year Cash Flow
Find the initial cost (steps)
1. Purchase price of new equipment/asset (always an outflow)
2. PLUS: Shipping and installation costs
3. PLUS: Any expenses necessary to get the equipment into working order. (the sum of 1 and 2 = depreciable value)
4. LESS: Proceeds from sale of old equipment
5. PLUS/MINUS: Tax expense/benefit from sale of old equipment
6. PLUS/MINUS: Increase/decrease in NWC
7. PLUS/MINUS: Misc. one-time, upfront inflows, such as a rebate, or outflows such as training cost
Find OCF (steps)
1. PLUS/MINUS: Increase/decrease in revenues
2. PLUS/MINUS: Decrease/increase operating expenses (includes change in depreciation)
3. PLUS/MINUS: Tax savings/expense from an increase/decrease in EBIT
4. PLUS/MINUS: Decrease/increase in NWC requirements
5. PLUS/MINUS: Tax benefit/tax expense (based on taxable income)
Find terminal year cash flow (steps)
1. Annual OCF in final year of project
2. PLUS: After-tax market value of the project
3. PLUS: Recapture of working capital
Replacement Project: Cash flows from sale of old equipment
1. Compare sale price (market or salvage value) to book value. If,
i. Sale Price > Book Value = Capital GAIN on sale.
-must pay taxes on the gain at the marginal tax rate
-taxes due = [marginal tax rate x (Sale price - BV)]
ii. Sale Price < Book Value = Capital LOSS on sale
-reduces overall tax obligation; tax benefit is created
-tax reduction = [marginal tax rate x (Sale price - BV)]
Cost of machine (depreciable value)
Purchase price + shipping and installation charges
GAAP accounting includes...
expected market/salvage value when calculating annual depreciation; TAX accounting does not.
we do not subtract the expected market/salvage value when calculating annual depreciation when calculating the depreciable value of plant/property/equipment
the sum of all previous annual depreciation expense
Cost / Estimated Useful Life
Initial cost of machine - accumulated depreciation
Change in NWC
Change in current assets - change in current liabilities
Net Present Value (NPV)
Calculate the present value of all future cash flows and subtract the initial cash outlay. Represents the value of a project in today's value. Also represents the dollar amount the value of the firm will go up or down. Also called discounted cash flow method.
Advantages of NPV
1. Considers the time value of money of cash flows
2. Considers risk by using a risk-adjusted discount rate
3. ** Allows for comparison of projects with different cash flows and different risk levels
4. Gives absolute dollar amount that firm value will increase or decrease (if assumptions are correct)
Disadvantages of NPV
It's based on estimates of cash flows and the required rate of return
Decision criteria (NPV rule)
1. If projects are independent (not using same resources), accept all projects with an NPV > 0
2. If projects are mutually exclusive, choose the one with the highest NPV
Cost of Capital
- the cost to a firm to obtain capital funding
- it equals the return to the providers of those funds (purchasers of stock or bonds)
What cost of capital represents
1. A firm's cost of capital indicates how the market views the risk of the firm's assets
2. A firm must earn at least the required return to compensate investors for the financing they have provided
3. The required return is the same as the appropriate discount rate the firm should use in valuing its activities or projects
Uses of cost of capital
1. Capital Budgeting Decisions - neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate
2. Financing Decisions - the optimal/target capital structure minimizes the cost of capital
Internal Rate of Return (IRR)
-Solving for the rate of return as if the NPV were zero
-It's the discount rate needed to break even
-It reveals the minimum required rate of return that prevents a loss on the project based on the estimated cash flows
IRR is constant, regardless of the _______________________
If IRR equals the required rate of return, NPV = _____
Advantages of IRR
1. Used by investors - easy to understand (gives a rate rather than number)
2. Allows for the comparison of projects with different cash flows and different levels of risk
Disadvantages of IRR
1. Possible multiple rates with unconventional cash flows. That is, if future negative cash flows are projected, the IRR method gives multiple IRR. In reality, there are times when an investment is expected to earn negative cash flows during its lifetime.
2. Different size project may conflict with NPV
3. If projects are mutually exclusive, may conflict with NPV
Decision Criteria (IRR)
1. If projects are independent, accept all projects with IRR equal to or greater than the required rate. But, if projects have future negative cash flows, use NPV.
2. If projects are mutually exclusive, choose the one with highest IRR, but only after checking NPV.
As the discount rate decreases, NPV....
If NPV is NEGATIVE, then discount rate (required return)...
exceeds the IRR
If NPV is POSITIVE, then IRR...
exceeds the discount rate (required return)
The LOWER the discount rate, the ____________ the NPV
NPV is __________ correlated to the discount rate
(NPV + IC) / IC
States the present value of the project in terms of the value of each dollar invested
Advantages of Profitability Index
1. Consistent with time value of money, typically leads to same decision as NPV
2. Incorporates risk via the required rate of return
3. Standardizes NPV in relation to each $1 invested
Disadvantages of Profitability Index
1. Difficult to accurately forecast the cash flows and the correct discount rate
2. Problems of scale. may give conflicting accept/reject decision if projects are mutually exclusive.
Decision Criteria (P.I.)
1. If projects are independent, choose all projects with a PI above 1
2. If projects are mutually exclusive, choose the one with the HIGHEST PI
Reveals the length of time to recover the firm's initial outlay in a new project
1. Easy to calculate and understand
2. Useful for small projects or for firms with limited access to capital
3. May allow management to see in a short time whether cash flow estimates are accurate
1. Ignores time value of money
2. Ignores cash flows after the initial investment is recaptured
3. Ignores risk
4. Biased against long-term projects
Decision criteria (payback)
1. If projects are independent, choose all projects with a payback period less than or equal to some predetermined length of time.
2. If projects are mutually exclusive, choose the one with the shortest payback that fits within the payback window.
-Limiting the amount of new capital investment
-Does NOT support the goal of the firm
Why does capital rationing happen?
1. Firm is unable to raise required financing
2. Firm does not have enough qualified managers to run the project
3. Company management is pessimistic about the economy (holding cash)
4. Other intangible reasons like fear of incurring debt or unwillingness to issue more stock
Capital Rationing Method
Rank projects using one of the evaluation method. Select the combination of projects that yield the HIGHEST TOTAL NPV without exceeding the firm's capital budget
only relevant if capital rationing or if projects are mutually exclusive
Special issues to consider when ranking projects
1. Problem of scale - different size projects
2. Reinvestment decision
- Time disparity problem - when capital will be available
- return on reinvestment
3. Unequal lives - projects with different EUL, constantly readjusting available capital amount
IRR doesn't tell you...
size or scale of project
Estimate Risk (how accurate are the estimates)
Scenario and Sensitivity Analysis
Could translate into a required rate of return because the greater the variation in results of these analyses, the higher the return necessary to generate a positive NPV for all cases
(Best case, base case, worst case). Change assumptions of performance and calculate NPV based on each case.
Multiple sets of cash flows with different assumptions
Isolates one variable (such as units sold) and determines change resulting from changes in this one item. Size of relative movement determines the sensitivity of the one element to changes
Effect of just changing 1 variable (sales/costs/etc)
Risk Adjusted Discount Rate
-Each project should be evaluated on the basis of its own risk
-Beginning point should be firm's WACC - the return the firm pays on average for new capital
-Add an adjustment for the risk of the project to WACC; the higher the risk, the greater the required return. Risk is the potential of variability in the cash flows
-Factors that influence risk
-The more uncertainty regarding future cash flows, the higher the required return necessary to compensate for the risk
Factors that influence risk
1. Size of the project
2. Length of the project (the longer the project, the greater the chance that estimates are incorrect or that circumstances determining return will change)
3. Experience or knowledge from which to make projections (the presence of comparable businesses or previous similar performance provides a benchmark for setting return)
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