Module 12: Capital Budgeting

______ ______ is the process by which firms allocate their scarce capital for future long term projects.

Capital budgeting is the process by which firms allocate their scarce capital for future long term projects.

In creating the pro forma financial statements for a project under consideration, the first and most important step is to determine which cash flows are _____ to the project. The key idea here is that only ______ cash flows associated with the project are included. The incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows that are a ______ ________ of taking the project. ____ costs and _______ costs are not included

In creating the pro forma financial statements for a project under consideration, the first and most important step is to determine which cash flows are relevant to the project. The key idea here is that only incremental cash flows associated with the project are included. The incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows that are a direct consequence of taking the project. Sunk costs and financing costs are not included

ICF

Incremental cash flows any and all changes in the firm's future cash flows that are a direct consequence of taking the project

Next we determine the changes in ___ _____ _____ for each period from the NWC values on the balance sheet - the ending NWC balance less the beginning NWC balance.

Next we determine the changes in net working capital for each period from the NWC values on the balance sheet - the ending NWC balance less the beginning NWC balance.

The NPV Rule states that only projects with a _____ NPV should be accepted. The IRR Rule states that projects should be accepted if its rate of return is _____ than that of the next best similar investment. The Payback Rule states that projects should be accepted only if its calculated payback period is ____ than a pre-specified period of time. Ideally all three rules should be met for a project to be accepted. However, since this may not always be the case, the ___ Rule is the primary capital budgeting rule in this course because it is perfectly aligned with the goal of ____ ________, assuming all the projections drawn from the pro formas are reasonably accurate.

The NPV Rule states that only projects with a positive NPV should be accepted. The IRR Rule states that projects should be accepted if its rate of return is greater than that of the next best similar investment. The Payback Rule states that projects should be accepted only if its calculated payback period is less than a pre-specified period of time. Ideally all three rules should be met for a project to be accepted. However, since this may not always be the case, the NPV Rule is the primary capital budgeting rule in this course because it is perfectly aligned with the goal of value maximization, assuming all the projections drawn from the pro formas are reasonably accurate.

pro forma financial statements

financial statements prepared to show the forecast or projected operating results and balance sheet for a project under consideration

PB rule

if a project's calculated payback period is less than the pre-specified period of time then the project should be accepted

NPV rule

if the PV of all cash inflows is greater than the PV of all cash outflows, then accept the project

IRR rule

if the projected IRR for a project is greater than the IRR on the next best investment of similar risk, then accept the project

bottom up approach

in calculating OCFs, start with NI and add back non cash items such as depreciation

MACRS

modified accelerated cost recovery system a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications

erosion

the CFs of a new project that come at the expense of a firm's existing products

payback period

the amount of time required for an investment to generate cash flows sufficient to recover its initial cost

stand-alone principle

the assumption that evaluation of a project is based on the project's ICFs

salvage value

the estimated re-sale value, or market value, of an asset at the end of its useful life

side effects

the impact, both good and bad, a new project has on the CFs of existing lines of business

cash from from assets (CFFA)

the stream of cash inflows and outflows generated by the firm's assets

The final step in the capital budgeting process is to use the decision rules to decide whether to accept or reject a project. The capital budgeting decision rulesinclude the ___ Rule, the ___ Rule, and the ______ Rule.

The final step in the capital budgeting process is to use the decision rules to decide whether to accept or reject a project. The capital budgeting decision rulesinclude the NPV Rule, the IRR Rule, and the Payback Rule.

The first step in this process is to create a table that includes the number _____ for the project (columns) and the definition of the ____ (rows). Recall that the definition of the CFFA has three components: ______ cash flows, changes in ___ _____ capital, and capital ______.

The first step in this process is to create a table that includes the number periods for the project (columns) and the definition of the CFFA (rows). Recall that the definition of the CFFA has three components: operating cash flows, changes in net working capital, and capital spending.

The initial capital investment is found at time zero in the ___ section of the balance sheet. This is a cash _____.

The initial capital investment is found at time zero in the PPE section of the balance sheet. This is a cash outflow.

The last component of the CFFA that we must determine is the net ____ _____ for each period with data taken from the balance sheet (____ value), the MACRS depreciation schedule (tax book value), and the market value (______ value) of the asset.

The last component of the CFFA that we must determine is the net capital spending for each period with data taken from the balance sheet (book value), the MACRS depreciation schedule (tax book value), and the market value (salvage value) of the asset.

The next step is to calculate the _____ ___ ____ for each period with data taken from the income statement using the bottom-up approach - start with net income and add back ________.

The next step is to calculate the operating cash flows for each period with data taken from the income statement using the bottom-up approach - start with net income and add back depreciation.

The process (cap budgeting) can be summarized as having three steps. The first step is to create the ___ ____ financial statements, specifically the income statement and balance sheet, for a project under consideration. Second, the firm extracts the ___ _____ from the pro formas for each forecasted point in time that the project will be in operation. Finally, once the cash flows are on the ______ the firm uses some decision rules to ultimately arrive at the decision to accept or reject the project.

The process (cap budgeting) can be summarized as having three steps. The first step is to create the pro forma financial statements, specifically the income statement and balance sheet, for a project under consideration. Second, the firm extracts the cash flows from the pro formas for each forecasted point in time that the project will be in operation. Finally, once the cash flows are on the timeline the firm uses some decision rules to ultimately arrive at the decision to accept or reject the project.

The rules are applied only ____ all of the project's estimated cash flows from assets(CFFA) have been determined and established on the _______.

The rules are applied only after all of the project's estimated cash flows from assets(CFFA) have been determined and established on the timeline.

When extracting information from the pro forma financial statementsthe ultimate goal is to determine the ___ ____ ____ ____ so that we can then apply the capital budgeting decision rules to decide whether or not we accept or reject a project.

When extracting information from the pro forma financial statementsthe ultimate goal is to determine the cash flows from assets (CFFA) so that we can then apply the capital budgeting decision rules to decide whether or not we accept or reject a project.

When the project is finished and the asset is sold we determine the ___ __ ___ ____ (ATSV) with data taken from the market price and the MACRS depreciation schedule. Assuming the asset can be sold at the end of project, the ATSV will result in a ____ ____ equal to the salvage value of the asset less ____ paid, or plus ____ refunded, on the ____ between the salvage value and the tax book value of the asset.

When the project is finished and the asset is sold we determine the after-tax salvage value (ATSV) with data taken from the market price and the MACRS depreciation schedule. Assuming the asset can be sold at the end of project, the ATSV will result in a cash inflow equal to the salvage value of the asset less taxes paid, or plus taxes refunded, on the difference between the salvage value and the tax book value of the asset.

With our estimates of the operating cash flows, changes in net working capital, and net capital spending complete, we fill in the table to arrive at the ____. We then use the values in the CFFA to find the project's NPV, IRR, and Payback Period.

With our estimates of the operating cash flows, changes in net working capital, and net capital spending complete, we fill in the table to arrive at the CFFA. We then use the values in the CFFA to find the project's NPV, IRR, and Payback Period.

sunk cost

a cost that has already been incurred and cannot be recovered and therefore should not be considered in an investment decision

depreciation

a method of allocating the cost of a tangible asset over its useful life

after tax salvage value (ATSV)

an estimate of the after tax value of an asset at the end of its depreciation