chapter 12

Decisions affected by uncertainties involved in

Annual costs and inflows Product life Interest rates Economic conditions And technological changes

standard decision rule for NPV Analysis

NPV > 0; accept the project because the project increases the firm value NPV < 0, reject the project because it reduces firm value

MIRR equation

fv of inflows / (1+ MIRR)^n

Four steps for a good Capital budgeting program

(1) search for and discovery of investment opportunities (2) collection of data (3) evaluation and decision making (4) reevaluation and adjustment the search for new opportunities is least emphasized, though most important

Internal Rate of Return Definition

A discounted cash flow method for evaluating Capital budgeting projects. discount rate that makes the present value of the cash and flows equal to the present value of the cash outflows

modified accelerated cost recovery system (MARCS)

A system that specifies the allowable depreciation recovery period for different types of assets. The normal recovery period is generally shorter than the physical life of the asset. Expected to remain applicable even after the current bonus depreciation program expires assets are classified according to nine categories to determine the allowable rate of depreciation write-off MARCs categories reference an older system called ADR (Asset Depreciation Range

Reinvestment Assumption: IRR

All inflows from given instrument can be reinvested at internal rate of return maybe unrealistic to assume reinvestment at equally High rate

Elective Expensing

Businesses can write off tangible properties such as equipment, furniture, tools, and computers and purchase year up to $1 million tax provision called Section 179 elective expensing Beneficial to small businesses allowances phased out dollar for Dollar on Total Property exceeding 2.5 million in a year

Modified Internal Rate of Return (MIRR)

Combines reinvestment Assumption of NPV method (cost of capital) with IRR method discount rates that equates future value of inflows, each growing at the cost of capital with investment

Tax cuts and jobs act of 2017

Congress wants businesses to invest more in Long lived assets, so at temporarily allows companies to take 100% bonus depreciation in the first year that an asset is placed in service

Capital expenditure decisions requires

Extensive planning Product design completion Patents acquired Capital markets tapped for needed funds

Selection Strategy

For project to be potentially accepted, Both the internal rate of return in the Net Present Value methods, profitability must equal or exceed the cost of capital for the project to potentially acceptable

Capital rationing

Occurs when a corporation has more dollars of capital budgeting projects with positive net present values than it has money to invest in them. Therefore, some projects that should be accepted are excluded because financial capital is rationed.

Methods of Ranking Investment Proposals

Payback method >>> While not conceptually sound, often used Net present value >> more acceptable Internal rate of return >> more acceptable

The Replacement Decision

The capital budgeting decision on whether to replace an old asset with a new one. An advance in technology is often involved. The Financial Manager often needs to determine whether a new machine with advanced technology can do the job better than the machine used presently Sale of old machine will have tax consequences some of the cash inflow from the sale will be taxable if the old machine is sold for more than it's remaining under appreciated book value, which is referenced as basis

how does IRR relate to NPV

The internal rate of return on an investment or project is the " rate of return" that makes the net present value of the project equal to zero The IRR is the Interest rate (i) that makes NPV = 0

Basis

The original price paid for an asset, adjusted for depreciation. Tax gains and losses are computed as the difference between the proceeds on the sale of an asset and the asset's adjusted basis. If it is sold for less than this value, there will be a loss on the sale of the replaced asset, and tax benefit will occur

Mutually Exclusive

The selection of one alternative will preclude the selection of any other alternative we select the alternative with the highest acceptable yield or highest net present value and disregard all others

Asset Depreciation Range (ADR)

This represents the expected physical life of an asset. Generally, the midpoint of the ADR is utilized to determine what class an asset falls into for depreciation purposes. MARCS Categories generally have shorter lives than the midpoint of the Matched ADR ranges that MARCS categories are built upon MARCS is designed for faster depreciation

cash flow

Value equal to income after taxes Plus non-cash expenses. In Capital budgeting decisions, non cash expense is usually depreciation Since depreciation does not represent an actual expenditure of funds and arriving at profit, it is added back to profit to determine the amount of cash flow generated

payback method

We compute the time required to recoup the initial investment

pocket calculator industry example

a number firms in the early 1970s had the hope of being first to break through the $100 price range for pocket calculator assuming that penetration of the $100 barrier would bring larger market share and higher probability technological advancement, price cutting, and appearance of Texas Instruments made prices go down by 60 to 90% and made the $100 pocket calculator a museum price first entry into the under $100 Market went bankrupt As other companies moved it to the market the demand for Quality went up and prices dropped

incremental analysis

an analytical approach that focuses only on those costs and revenues that change as a result of a decision

For Investments with a very high IRR, it may be unrealistic to ____

assume that the reinvestment can occur at an equally High rate

payback method advantages

easy to understand emphasizes liquidity useful in Industries characterized by Dynamic technological developments

in cash flows, You must be sensitive to the ____

executives concessions to short-term pressures the emphasis is on use of proper evaluation techniques to make the best economic choices and ensure long-term wealth maximization

t/f: Using the payback method can be appropriate when the time value of money is considered.

false

t/f: When net present value and internal rate of return analysis provide inconsistent rankings of projects, the financial manager should generally move forward with the project that has the highest internal rate of return.

false

t/f: Under MACRS depreciation, the tax life of an asset and its economically useful life are assumed to be the same.

false

t/f: In most capital budgeting decisions, the emphasis should be on reported earnings rather than cash flows.

false Cash flow is given more emphasis in capital budgeting decisions than earnings.

t/f: Under MACRS depreciation, taxes paid in the first year of an asset's life are subtracted from the base used to calculate depreciation expense.

false It would be inaccurate and inappropriate to adjust for tax savings in calculating a depreciable base.

t/f: A good capital budgeting program requires that a number of steps be taken in the decision-making process. The first step is the explanation of data.

false The first step involves searching for investment opportunities.

reasons for capital rationing

fear of too much growth hesitation to use external sources of fun BUT it can hinder firm from achieving maximum profitability

Capital budgeting is important to those in

finance or accounting and essential for people throughout the business organization must be familiar with your product but also with its Financial viability

Two exceptions where the IRR and NPV will have same decision

if investment has positive NPV, IRR exceeds the cost of capital in certain cases, methods give different answers and selecting best investment

payback shortcomings

ignores cash inflows after the cutoff. does not consider time value of money cannot find optimum or most economic solution to Capital budgeting problem

Reinvestment assumption NPV

makes more conservative assumption that each inflow can be reinfested at cost of capital or discount rate allows for certain consistency as inflows from each project are assumed to have the same investment opportunity

Capital budgeting decision involves

planning expenditures for project within minimum period of year or longer

____ is a prime characteristic of internal rate of return

reinvestment assumption

many several additions to basic investment situation for replacement decision:

sale of old machines tax consequences

net present value

sum of the present values of all outflows and inflows related to a project often preferred investment selection method for two important reasons it is a theoretically valid method well understood and used by Real World Finance professionals the present value of each inflow and outflow is usually discounted using the weighted average cost of capital Ka for the firm Inflows that arrive in later years must provide a return that at least equals the cost of invested capital

Rules of Depreciation

tax law changes in 2017 have complicated how depreciation is calculated for tax purposes Congress wants businesses to invest more and long-lived assets, so it temporarily allows companies to make 100% bonus depreciation in the first year that an asset is placed in service bonus will begin in 2023 and expire by 2027

While NPV measures the attractiveness of a project in dollar terms, the IRR measures ____

the profitability of Investments as a return percentage- much like finding the interest rate (i) in a time value of money problem

replacement decision could be analyzed by

total analysis of the third and the Machines incremental analysis of cash flow changes between old and new machines

t/f: For a small business, it is possible for the purchase price of an asset to be expensed rather than depreciated.

true

t/f: Non-mutually exclusive alternatives can be accepted at the same time.

true

t/f: The payback method is very basic but it gives the user an understanding of when the cost of the initial project will be completely paid off.

true

t/f: Under the net present value method, cash flows are assumed to be reinvested at the firm's weighted average cost of capital.

true

t/f: IRR equates the present value of inflows (project returns) to an outflow (the project's cost)

true

t/f: The Net Present Value makes more conservative assumption that each inflow can be reinvested at the cost of capital or discount rate

true

t/f: as the time Horizon moves further into the future, uncertainty becomes a greater hazard

true

t/f: collection of data should go beyond engineering data and Market surveys should attempt to capture relative likelihood of occurrence of various events

true

t/f: for the large MARCS table, the year five will use 6 years, the 7 years will use 8 years, etc. this table is used to calculate depreciation and multiplied with EBIT

true

t/f: large corporations with foreign tax obligations May pay higher or lower effective rates

true