Chapter 8

The Cost of capital as a screening tool: IRR Method

Cost of capital is compared to the IRR of a project. Any project whose IRR is less than the cost of capital is rejected unless other factors dictate acceptance

The Cost of capital as a screening tool: NPV method

Cost of capital is used as the discount rate when computing the NPV of a project. Any Project with a negative NPV is rejected unless other factors dictate acceptance

Working Capital

Current assets (Cash, AR, inventory) - current liabilities. When a new project is started the balances in the current asset account usually increase.

Simple Rate of Return Method

Does not involve discounting cash flows. Focuses on discounting net operating income. The Initial investment should be reduced by any salvage value from the sale of the old equipment.

Criticism of the Simple Rate of Return Method

Doesn't consider the time value of money. SRR fluctuates from year to year when used to evaluate projects that do not have constant annual incremental revenues and expanses. The same project may appear desirable in some years and not in others

Relevant Costs

Expand the NPV method to include 2 alternatives and the concept of _____________

Payback Method Shortcomings

Ignores cash flows after the payback period, has no inherent mechanisms for highlighting differences in useful life b/w alternatives. Ignores the time value of money.

Least cost Decisions

In decisions where revenues are not directly involved, managers should choose the alternative that has the least total cost from a present value perspective.

Cash Inflows

Incremental Revenues, Reduction in costs, salvage value, release of working capital

Cash Outflows

Initial investment (including instillation costs), Increased working capital needs, repairs and maintenance, Incremental operating costs

Present Value for the IRR =

Investment required divided by annual net cash flows =

Cash Flows

NPV emphasizes

Preference Decisions

Relate to selecting among several competing courses of action. EX: A company may be considering several different machines to replace an existing one on the assembly line

Screening Decisions

Relate to whether a proposed project is acceptable, whether it passes a preset hurdle. EX: A company may have a policy of accepting projects only if they provide a return of at least 20% on the investment

Expansion Decisions

Should a new plant, warehouse, or other facility be acquired to increase capacity and sales?

Equipment replacement Decisions

Should old equipment be replaced now or later?

The more desirable the project is

The higher the profitability index is....

The constrained resource

The limited funds available for investment is usually

Capital Budgeting

Used to describe how managers plan significant investments in projects that have long term implications such as the purchase of new equipment or introducing new products

Payback Method and uneven Cash flows

When the cash flows associated with an investment present change from year to year, the Payback Method cannot be used. Instead the un-recovered investment must be tracked year by year

Screening Device

When the cost of capital is used as the discount rate, it serves as a _________ in NPV analysis

The Cost of capital

acts as a hurdle rate that a project must clear for acceptance in IRR

2 simplifying Assumptions for NPV

1. All cash flows other than the initial investment occur at the end of periods 2. All cash flows generated by an investment project are immediately reinvested at a rate or return equal to the discount rate

Time value of Money

A dollar today is worth more than a dollar a year from now. Projects that promise earlier returns are preferable to those that promise later returns.

Post Audit of Investment Projects

A follow up after the project has been completed to see whether or not expected results were actually realized

Out of Pocket Costs

Actual cash outlays for salaries, advertising, and other operating expenses

Rejected

Any project with a rate of return less than the cost of capital should be

Accounting Net Income

Based on accruals that ignore the timing of cash flows in and out of an organization

Same Answer

Both the Total Cost Approach and the Incremental Approach give the

Capital Budgeting Analysis/decisions

Can be used for any decision that involves an outlay now in order to obtain some future return

Strenghts of the Payback Method

Can serve as a screening tool to help identify which investment proposals are in the ballpark. Can aid companies that are cash poor in identifying investments that will recoup cash investments quickly. Can help companies that compete in industries where products become obsolete rapidly to identify products that will recoup their initial investments quickly.

Preference Decisions

Come after scanning decisions. Attempt to rank acceptable alternatives from the most to least appealing. Need to be made b/c the # of acceptable investment alternatives usually exceeds the amount of available funds

The NPV Method

Compares the present value of a projects cash inflows with the present value of it's cash outflows. The difference b/w the 2 determines if the project is an acceptable investment

IRR is computed by

Finding the discount rate that will cause the NPV of a project to be zero

Payback Method

Focuses on the payback period. Not a true measure of the profitability of an investment. Only tells how many years are required to recover the initial investment. A shorter payback period does not always mean that one investment is better than another.

Questionable Assumption of IRR

IRR assumes cash inflows are reinvested at the IRR. If the IRR is high, this assumption may be unrealistic. Its more realistic to assume that the cash flows can be reinvested at the discount rate

Trial and error process

If the annual cash flows are not identical when determining IRR a __________ must be used

The profitability index

Is similar to the Contribution margin per unit of the constrained resource

NPV

Methid that is often simpler to use

Required Rate of Return

Minimum rate of return a project must yield to be acceptable

The Total Cost Approach

Most flexible method. Includes all cash flows associated with each alternative. NPV is computed for each alternative. This is an advantage b/c an unlimited # of alternatives can be compared side by side to determine the best option.

Depreciation

Not deducted in computing NPV b/c it is not a current cash outflow. Discounted cash flow methods automatically provide for return of the original investment

Screening Decisions

Pertain to whether or not some proposed investment is acceptable, these decisions come first

Deductible Expenses

Reduce net income, so reduces the amount of taxes to be paid

Incremental Approach

Simpler and more direct route to a decision when 2 alternatives are being compared. Only the costs and revenues that differ b/w the alternatives are included.

After Tax Cost

Taxable income is the same as the income stated in financial reports. Net Income. There is a flat tax rate on the entire taxable income.

Discounted Cash Flows

Techniques that best recognize the time value of money

Original Investment

The NPV method automatically provides for return of the _________.

Investments are equal

The NPV of one project cannot be directly compared to the NPV of another unless the

NPV is Zero

The Project is acceptable if it promises a return equal to the req rate of return

Positive NPV

The Project is acceptable if it promises a return greater than the req rate of return

Equal to or greater

The Project is acceptable if the IRR is _________ than the minimum required rate of return

Negative NPV

The Project is not acceptable if it promises a return less than the req rate of return

Less than

The Project is rejected if the IRR is _________ than the required minimum rate of return

Cost Of Capital

The average rate of return the company must pay to it's long term creditors and it's shareholders for the use of their funds

IRR Method

The rate of return promised by an investment project over its useful life. Sometimes called the yield on a project. Works well if the projects cash flows are identical each year.

Higher, more desirable

When using the IRR to rank competing investment projects, the preference rule is the _______ the IRR, the ________ the project is

NPV is positive

Whenever the ____________, the project will recover the original cost plus sufficient excess cash inflows to compensate for tying up funds in the project

Equipment Selection Decisions

Which of several available machines should be purchased?

Initial Investment

Working Capital is treated as part of the _______ of a project

Cost reduction decisions

should new equipment be purchased to reduce costs?

Payback period

the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.