Chapter 9 Finance

9-3b Independent Projects (pg.152)

*If a project's NPV is positive, its IRR will exceed r; if NPV is negative, r will exceed the IRR.* *In every case, if a project is acceptable using the IRR method, then the NPV method also will show that it is acceptable.*

-Post-Audit (pg.146)

A comparison of the actual and expected results for a given capital project.

9-3a NPVs and Required Rates of Return---NPV Profiles (pg.151-152)

A graph that shows a project's NPV at various discount rates (required rates of return) is termed the project's *net present value (NPV) profile.* Because the IRR is defined as the discount rate at which a project's NPV equals zero, the point where its *NPV profile crosses the X-axis indicates a project's internal rate of return.* -*Crossover Rate*= when the NPVs are equal and intersect. (pg.151-152) -As a general rule, the impact of a change int he discount rate is much greater on distant cash flows than on near-term cash flows.

-Net Present Value (NPV) Profile (pg.151)

A graph that shows the NPVs for a project at various discount rates (required rates of return).

*Budget* (pg.144)

A plan that details projected cash inflows and cash outflows during some future period.

9-3d Cash Flow Patterns and Multiple IRRs (pg.153-154)

A project has a *conventional* cash flow pattern if it has cash outflows (costs) in one or more consecutive periods at the beginning of its life, followed by a series of cash inflows. ~If, however, a project has a large cash outflow at the beginning of its life, and then has another cash outflow either at some time during its life or at the end of it, then it has an *unconventional* cash flow pattern. -Projects with unconventional cash flow patterns present unique difficulties when the IRR method is used, including the possibility of *multiple IRRs.* -There exists an IRR solution or each time the *direction* of the cash flow associated with a project is interrupted, that is, each time outflows change to inflows.

-Mutually Exclusive Projects (pg.146)

A set of projects in which the acceptance of one project means the others cannot be accepted. *Only one mutually exclusive project can be purchased, even if they all are acceptable.*

9-1c The Post-Audit (pg.146-147)

An important aspect of the capital budgeting process is the *post-aduit,* which involves (1) comparing actual results with those predicted by the project's sponsors (2) explaining why any differences occurred. The post-audit is not a simple process; a number of factors can cause complications. 1.) We must recognize that each element of the cash flow forecast is subject to uncertainty, so a percentage of all projects undertaken by any reasonably venturesome firm will necessarily go awry. 2.) Projects sometimes fail to meet expectations for reasons beyond the control of the operating executives and for reasons that no one could realistically be expected to anticipate. 3.) It is often difficult to separate the operating results of one investment from those of a larger system. ~Might be hard to measure 4.) It is often hard to hand out blame or praise, because the executives who were actually responsible fora given decision might have moved on by the time the results of a long-term investment are known. -We regard the post-audit as being an extremely important element in a good capital budgeting system.

9-2 EVALUATING CAPITAL BUDGETING PROJECTS (pg.147-150)

Capital Budgeting Steps: 1.) Estimate the cash flows expected to be generated by the asset during its life. 2.) Evaluate the riskiness of the projected cash flows to determine the appropriate rate of return to use for computing the present value of the estimated cash flows. 3.) Compute the present value of the expected cash flows---that is, compute the investment's value. 4.) Compare the present value of the future expected cash flows with the initial investment, or cost, required to acquire the asset. ~Alternatively, the expected rate of return not he project can be calculated and compared with the rate of return that is considered appropriate (required) for the project. *If a firm identifies (or creates) an investment opportunity with a present value (the value of the investment to the firm) that is greater then its cost, the value of the firm will increase if the investment is purchased.* ^Thus, there is a direct link between capital budgeting and stock values: The more effective the firm's capital budgeting procedures, the higher the price of its stock.

9-1b Project Classifications (pg.146)

Capital budgeting decisions generally are termed either *replacement decisions* or *expansion decisions.* Some of the capital budgeting decisions involve *independent projects,* while others involved *mutually exclusive* projects.

-Replacement Decisions (pg.146)

Decisions whether to purchase capital assets to take the place of existing assets to maintain or improve existing operations.

-Expansion Decisions (pg.146)

Decisions whether to purchase capital projects and add them to existing assets to increase existing operations.

9-5a Payback Period: Traditional (Nondiscounted) and Discounted (pg.156-158)

Many managers like to know how long it will take a project to repay its initial investment (cost) from the cash flows it is expected to generate in the future. -Using the payback to make capital budgeting decisions is based on the concept that it is better to recover the cost of (investment in) a project sooner rather than later. *As a general rule, a project is considered acceptable if it spy aback period is less than the maximum cost-recovery time established by the firm.* *PB Decision Rule*: A project is acceptable if PB<n* n*= the recovery period that the firm has determined is appropriate. -The payback method is simple, which explains why payback traditionally has been one of the most popular capital budgeting techniques. ~However, because the traditional payback period computation ignores the time value of obey, replying solely on this method can lead to incorrect decisions, at least if our goal is to maximize value.

-Independent Projects (pg.146)

Projects whose cash flows are not affected by decisions made about other projects. *All independent projects can be purchased if they all are acceptable.*

*Capital* (pg.144)

Refers to fixed (long-term) assets used in production.

9-2a Net Present Value (NPV) (pg.147-149)

The NPV show by how much a firm's value, and thus stockholders' wealth, will increase if a capital budgeting project is purchased. *If the net benefit computed on a present value basis---that is, NPV---is positive, then the asset (project) is considered an acceptable investment.* In other words, to determine whether a project is acceptable using the NPV technique, we apply the following decision rule: *NPV Decision Rule*: A project is acceptable if NPV> $0. -The rationale for the NPV method is straightforward. An NPV of zero signifies that the project's cash flows are just sufficient to repay the invested capital and to provide the required rate of return (r) on that capital. ~If a project has a positive NPV, then it generates a return that is greater than is needed to pay for funds provided by investors, and this excess rerun accrues solely to the firm's stockholders. ~Therefore, if a firm takes on a project with a positive NPV, the position of the stockholders is improved because the firm's value increases.

-Reinvestment Rate Assumption (pg.153)

The assumption that cash flows from project can be reinvested (1) at the cost of capital, if using the NPV method (2) at the internal rate of return, is using the IRR method

-Required Rate of Return A.K.A. Hurdle Rate (pg.150)

The discount rate (cost of funds) that the IRR must exceed for a project to be considered acceptable. *You do not need to know the firms required rate of return (r) to solve for IRR.* ~However, you need the required rate of return to make a decision as to whether a project is acceptable once its IRR has been computed.

-Internal Rate of Return (IRR) (pg.149)

The discount rate that forces the PV of a project's expected cash flows to equal its initial cost; IRR is similar to the YTM on a bond. ~The rate of return the firm expects to earn if a project is purchased and held for its useful life (maturity). *As long as the project's IRR, which is the average return it is expected to generate each year of its life, is greater then the rate of return required by the firm for such an investment, the project is acceptable.* *IRR Decision Rule*: A project is acceptable if IRR> r. ~Where r is the firm's required rate of return. [the discount rate is the IRR] Also, note that (1) the IRR is the rate of return that will be earned by *anyone* who purchases the project (2) the IRR is dependent on the project's cash flow characteristics (that is, the amounts and he timing of the cash flows), not the firm's required rate of return. *Taking on a project whose IRR exceeds the firms required rate of return (cost of funds) increases shareholders' wealth.*

-Traditional Payback Period (PB) (pg.156)

The length of time it takes to recover the original cost of an investment from its unadjusted (raw) expected cash flows. ~Which is defined as the expected number of years required to recover the original investment (the cost of the asset).

-Net Present Value (NPV) (pg.147)

The present value of an asset's future cash flows minus its purchase price (initial investment). Also called net dollar value and net benefit. -Cash outflows (expenditures on the project, such as the cost of buying equipment or building factories) are treated as negative cash flows. ~Ex. ^CFo generally is a negative cash flow bc it represents the initial investment in the object, which normally is a cash outflow when the product is purchased (Period 0).

-Capital Budgeting (pg.145)

The process of planning and expenditures on assets whose cash flows are expected to extend beyond one year.

-Multiple IRR (pg.154)

The situation in which a project has two or more IRRs.

9-1 IMPORTANCE OF CAPITAL BUDGETING (pg.145-147)

Thus, the capital budget is an outline of planned expenditure on fixed assets, and *capital budgeting* is the process of analyzing projects and deciding (1) which are acceptable investments (2) which should actually be purchased A number of factors combine to make capital budgeting decisions among the most important ones that financial managers must make. Timing is also important in capital budgeting. Capital assets must be ready to come on line when they are needed; otherwise, opportunities might be lost. -Effective capital budgeting can improve both the timing of asset acquisitions and the quality of assets purchased. ~A firm that forecasts its needs for capital assets in advance will have an opportunity to purchase and install the assets before they are needed. -If many firms order capital goods at the same time, backlogs result, prices increase, and the firms are forced to wait for the delivery of machinery; in general, the quality of the capital goods deteriorates. ^ If a firm foresees its needs and purchases capital assets early, it can avoid these problems. -Finally, capital budgeting is important because the acquisition of fixed assets typically involves substantial expenditures, and before a firm can spend a large amount of money, it must have the funds available. ~Large amounts of money are not available auto magically. Therefore, a firm contemplating a major capital expenditure program must arrange its financing well in advance to ensure that the required funds are available.

9-5b Conclusions on the Capital Budgeting Decision Methods (pg.158-159)

Traditional payback and discounted payback provide information about both the risk and the *liquidity* of a project. A long payback means that (1) the investment dollars will be locked up for many years, hence the project is relatively illiquid (2) the object's cash flows must be forecast far out into the future, hence the project is probably quite risky. NPV is important because it gives a direct measure of the dollar benefit (on a present value basis) to the firm's shareholders, so we regard NPV as the best single measure of *profitability.* ~IRR also measures profitability, but here it is expressed as a percentage rate of return, which many decision makers, especially non financial managers, seem to prefer.

9-3c Mutually Exclusive Projects (pg.152-153)

We concluded that the *more realistic **reinvestment rate assumption** is the required rate of return, which is implicit in the NPV method.* ~This, in turn, leads us to prefer the NPV method, at least for firms willing and able to obtain new funds at a cost reasonably close to their current cost of funds. -Remember that when projects are independent, the NPV and IRR methods provide the same accept/ reject decision. As a result, when evaluating independent projects, it doesn't matter whether the NPV technique or the IRR technique is used to make the investment decision, because the firm only wants to know whether the projects are acceptable (value increasing) or unacceptable (value decreasing). ~However, when vaulting mutually exclusive projects, especially those that differ in scale or timing, the NPV method should be used to determine which project should be purchased. In this case, because only one project can be purchased, the firm must determine which project is most acceptable; that is, which project adds the greatest value to the firm.

9-3 COMPARISON OF THE NPV AND IRR METHODS (pg.150 -154)

We generally measure wealth in dollars, so the NPV method should be used to accomplish the goal of maximizing shareholders' wealth. We choose to discuss the IRR method and compare it to the NPV method because many corporate executives are familiar with the meaning of IRR, it is entrenched in the corporate world, and it does have some virtues. ~For these reasons, it is important to understand the IRR method and be prepared to explain why a project with *a lower IRR might sometimes be preferable to one with a higher IRR.*

9-1a Generating Ideas for apical Projects (pg.145-146)

Whereas a set of stocks and bonds already exists in the finical markets and investors select from this set, capital budgeting projects are created by the firm. Ex. If it appears likely that a significant market does exist, cost accountants and engineers will be asked to estimate production costs. If those estimates show the product can be produced and sold at a sufficient profit, the project will be undertaken.