FIN test 5

Free cash flow = Operating cash flow - Capital spending - Additions to Net Working Capital

Operating cash flow = (EBIT + Depreciation) - Taxes Operating cash flow is earnings before interest plus depreciation minus taxes. And, it's important to remember that these cash flows have not yet occurred--we estimate what they would be if the project were to be adopted. Capital spending is the cash that must be invested in the project's capital assets to produce the projected operating cash flow! Any operating cash flow that must be invested in productive assets is not available for the company's security holders, so the projected capital expenditures must be subtracted from the operating cash flow. Additions to Net Working Capital are investments in the project's short-term assets. A project may require investments in such items as accounts payable and inventory. Some operating cash flow may have to be invested in these short-term assets and is thus not available (free) to be paid to the security holders.

nominal/discount rate

(1 + Nominal rate ) = (1 + real rate)(1 + inflation rate) An interest rate that is not adjusted for inflation. Is the rate we see reported in business news, is used in contracts and valuing securities, and is generally used in capital budgeting projects.

5 Rules for Capital Budgeting

- 1. Include only cash flows, in your calculations - Only the direct cash inflows and outflows created by the project are included. For example, a company may have five accountants on staff. The salaries for these accountants are not allocated to the project unless an accountant is hired as a direct result of taking on the project. 2. Include the impact of the project on cash flows from other product lines - ECONOMIC INTERDEPENDENCIES occur when the project would change the cash flows in other parts of the company. For example, many grocery stores are installing gas pumps. Evaluation of these pumps must include not only gas sales, but also the increased sale of groceries to people who are filling up. This positive effect where the project would increase the cash flows from existing operations is called SYNERGY. On the other hand, a bricks-and-mortar store that introduces online shopping may suffer a loss in sales from its physical stores. This reduction in the cash flows of existing operations is called EROSION. 3. Include all opportunity costs - Even if a company already owns an asset, the asset must be included in the project evaluation. For example, imagine a company is evaluating a plant expansion that would use a vacant lot the company already owns. This lot could be sold for a considerable amount of money. Thus, the cost of the alternate use of the lot (its sale price) must be included as a project cash outflow 4. Forget Sunk Costs - Sunk costs are costs that have already been incurred. As such they are not incremental cash flows and are irrelevant for capital budgeting decisions. Only future inflows and outflows should be considered. Imagine that last week you put new tires on your car. This week, the transmission went out. Your previous expenditure on tires is irrelevant. The only cash flows you should consider are the costs of a new transmission compared to the current value of the vehicle. 5. Include only after-tax cash flows in the cash flow calculation(each project should be evaluated using marginal tax rates.)

2 Traditional Decision Rules

1) Payback period = Cost of project / Annual cash inflow calculates the amount of time it takes for a project to "payback" its initial investment. The shorter the payback period the quicker the company gets its initial investment back and begins to see a profit. Managers set the maximum payback period they will accept. It's limited by not applying time value, opportunity cost, or all cashflows into account. Mainly used in small/simple projects or when it's difficult to forecast discount rates/ cashflow. 2) AAR = Average net income / Average book value adjusted for depreciation the rate of return earned on a project. It is calculated by comparing the average net income earned by a project to the cost of the project, measured by the average book value. Managers will set a minimum AAR. While useful for some purposes the AAR is not based on future cash flows, doesn't recognize time value, and does not use the opportunity cost. It is thus of limited use in making decisions about the future.

A project that provides annual cash flows of $2,145 for eight years costs $8,450 today. Is this a good project if the required return is 8 percent?

1. Enter Initial cash flow (-8450) Press CFj 2. Enter the first operating cash flow (2,145) then press the CFj 3. Enter number of periods (8) then press downshift and then CFj 4. Enter required return (8) then Press I/YR 5. Press downshift key then press PRC/NPV At an 8 percent required return, the NPV is positive (3,876.54), so we would accept the project. At what discount rate would you be indifferent between accepting the project and rejecting it? We would be indifferent to the project if the required return was equal to the IRR of the project, since at that required return the NPV is zero. Press Downshift and Press CST/IRR to get the IRR of 19.13

Potential Disadvantages of Capital Rationing

1. High capital requirements - Because only the most profitable investments are taken. 2. Goes against the efficient capital markets theory - Instead of investing in all projects that offer high profits, capital rationing only allows for selecting the projects with the highest estimated returns on investment. But the efficient markets theory holds that it is virtually impossible, over time, to continually select superior investments that significantly outperform others.

Inflation-Adjusted Cash Flows and NPV

1. Initial cashflows arent impacted 2. Deflate future cashflows based on inflation rate and period they will be recieved (cashflow/(1+ inflation rate)^period) 3. calculate Real Rate of Interest ((1 + Nominal rate ) = (1 + real rate)(1 + inflation rate)) 4. Discount deflated future cash flows based on the real discount rate ((deflated cashflow/(1+ real rate)^period))

IRR 1. Describe how the IRR is calculated, and describe the information this measure provides about a sequence of cash flows. What is the IRR criterion decision rule? 2. What is the relationship between IRR and NPV? Are there any situations in which you might prefer one method over the other? Explain. 3. Despite its shortcomings in some situations, why do most financial managers use IRR along with NPV when evaluating projects? Can you think of a situation in which IRR might be a more appropriate measure to use than NPV?

1. The IRR is the rate of return earned on an investment. It is the discount rate that causes the NPV of a series of cash flows to be equal to zero. IRR can thus be interpreted as a financial break-even rate of return; at the IRR discount rate, the net value of the project is zero. For investments, the IRR decision rule is to accept projects with IRRs greater than the opportunity cost. 2. IRR is the interest rate that a project earns, whereas the required rate of return is the opportunity cost of the project: the rate of return the project should earn given its risk. NPV directly uses the opportunity cost to evaluate the project's cash flows, and is thus is preferred in all situations to IRR. For stand-alone projects with conventional cash flows, IRR and NPV are interchangeable techniques; however, IRR can lead to ambiguous results if there are non-conventional cash flows, and also ambiguously ranks some mutually exclusive projects. 3. IRR is frequently used because it is easier for many financial managers and analysts to rate performance in relative terms, such as "12%" than in absolute terms, such as "$46,000." IRR may be a preferred method to NPV in situations where an appropriate discount rate is unknown or uncertain; in this situation, IRR might provide more information about the project than would NPV.

profitability index 1. Describe how the profitability index is calculated and describe the information this measure provides about a sequence of cash flows. What is the profitability index decision rule? 2. What is the relationship between the profitability index and the NPV? Are there any situations in which you might prefer one method over the other?

1. The profitability index is the present value of the future cash flows, discounted by the opportunity cost, divided by the initial investment. It measures the wealth created per dollar invested, providing a measure of the relative profitability of a project. The profitability index decision rule is to accept projects with a PI greater than one, and to reject projects with a PI less than one. A PI greater than one indicates that the project will return more than a dollar for each dollar invested, with this comparison using proper time value analysis. 2. Whereas NPV measures the total wealth creation of a project, PI gives the wealth creation per dollar invested. If capital is limited then the firm has more acceptable projects than investments funds available. In these situations PI may provide a good ranking measure of the projects, indicating the "bang for the buck" of each particular project. Projects would be ranked by PI. The highest PI-project would be selected, then the next highest PI-project, until all available funds have been committed.

1. Describe how NPV is calculated and describe the information this measure provides about a sequence of cash flows. What is the NPV criterion decision rule? 2. Why is NPV considered to be a superior method of evaluating the cash flows from a project? Suppose the NPV for a project's cash flows is computed to be $2,500. What does this number represent with respect to the firm's shareholders?

1. a way of doing cost-benefit analysis. For most projects their cash flows occur at different points in time. A valid comparison is possible only if these cash flows can be restated as of a single point in time. This involves using the opportunity cost, which reflects the basic time value of money (risk free interest rate) and an appropriate risk premium. NPV takes into account all aspects of economic value: cash flows, the timing of these cash flows, and the risk-adjusted opportunity cost. The NPV decision rule is to accept projects that have a positive NPV, and reject projects with a negative NPV. 2. NPV is superior to the other methods of analysis presented in our course because it directly measures a decision's impact on wealth. The only drawback to NPV is that it relies on cash flow and discount rate values that are often estimates and not certain, but this is a problem shared by the other performance criteria as well. A project with NPV = $2,500 implies that the total shareholder wealth of the firm will increase by $2,500 if the project is accepted. This does not mean the shareholders get a check for that amount: it is a statement of the expected increase in wealth given the project, which should be reflected by an increase in the stock price.

A firm evaluates all of its projects by applying the IRR rule. If the required return is 11 percent, should the firm accept the following project? Year / CashFlow 0 / -168,500 1 / 86,000 2 / 91,000 3 / 53,000

1. enter the initial cash flow(-168500) and hit the CFj key 2. enter Cash flow 1 (86000) and hit the CFj key 3. enter Cash flow 2 (91000) and hit the CFj key 4. enter Cash flow 3 (53000) and hit the CFj key 5. To get IRR press downshift then CST/IRR Your project earns an IRR of 18.8% As equivalent investments earn 11%, this is an attractive investment. What if the required return was 21 percent? To get the NPV at 21%, just enter 21, press the I/YR button, then downshift and PRC/NPV With a discount rate of 21% we get a negative NPV of -$5354

Internal Rate of Return (IRR)

= (PV Inflows - PV outflows) / PV outflows The rate of return earned on a project. To make a decision managers must compare the IRR to the opportunity cost/discount rate. They should only accept the project if it earns (IRR) more than should be expected (RRR) given other projects of equivalent risk.

Annual depreciation expense

= (cost - salvage value) / Project life

Operating cash flow

= Net Income + Depreciation The cash flow of the project that is available for investment in further production or payment to security holders.

Net income

= Net operating Income - Taxes which measures the profit accruing to shareholders. Capital budgeting does not factor in interest expense(payment to bondholders).

Net Present Value (NPV)

= PV Inflows - PV outflows a dollar measure of the impact of a project on the company's wealth. It uses the opportunity cost to bring all of the project's incremental cash flows back to the present and then compares inflows to outflows to see if the project is acceptable.

Profitability Index (PI)

= PV Inflows / PV outflows ration measure of the wealth creation (NPV) per dollar invested.

Net operating income(EBIT)

= revenues - costs of production - depreciation measures the direct operating profit

Indivisible projects

A company may adopt a project in its entirety or not, but cannot take a portion of a project. Managers look for a combination of projects that produces the highest NPV without exceeding the capital budget. ex: If you are building a bridge, then you'll build the entire bridge, not just go halfway across the river.

Capital budgeting and competition

A positive NPV project is quite valuable. If a company is doing something neat other companies will muscle in on that lucrative market, such as the iPhone being squeezed by producers such as Samsung and other Android-based smartphones. Companies must thus constantly innovate, and seek to reduce costs, to stay up with the competition!

real interest rate

An interest rate reflecting the real change in purchasing power of a currency. measures the real increase in the purchasing power of amount over time: how much actual purchasing power of money is expected to increase.

Calculating AAR You're trying to determine whether or not to expand your business by building a new manufacturing plant. The plant has an installation cost of $12.5 million, which will be depreciated straight-line to zero over its four-year life. If the plant has projected net income of $1,368,000, $1,935,000, $1,738,000, and $1,310,000 over these four years, what is the project's average accounting return (AAR)?

Average net income = ($1,368,000 + 1,935,000 + 1,738,000 + 1,310,000)/4 = $1,587,750 The average book value is the average value in the balance sheet for the assets. For straight-line depreciation with no salvage value we can just add the beginning and ending book values and divide by two. Average book value = ($12,500,000 + 0)/2 = $6,250,000 1,587,750 / 6,250,000 = .2540 or 25.4%

Managerial Decisions

Capital budgeting decision: What productive assets should the firm obtain? This decision is guided by the customers the corporation seeks to satisfy. Capital Structure decision: Productive assets are not cheap! The corporation must raise capital from investors by issuing financial securities to finance its operations. Net Working Capital decision: The corporation must be able to manage its short-term expenses.

Capital Budgeting in Not-for-Profit Entities

Capital budgeting is crucial for not-for-profit entities and governments. It is frequently the case that the "revenues" from not-for-profit ventures are not tangible, but rather benefits that are difficult to measure, such as quality of life for the disabled. These organizations also have no stock price or market determined discount rate to use in their decisions. However, like for-profit corporations, cost-benefit analysis is important and must be done as effectively as possible given these limitations.Finally, realistic cost/benefit analysis should definitely be used by the U.S. government and would go a long way toward balancing the budget! In fact, cost-benefit analysis is often written into the laws passed by Congress and state legislatures. The major difficulty here is that government benefits/contracts/payments for some groups are considered "fat" by others, so the allocation is often done along political, not economic or true social lines.

Sunk Costs Kenny, Inc., is looking at setting up a new manufacturing plant in South Park. The company bought some land six years ago for $5.3 million in anticipation of using it as a warehouse and distribution site, but the company has since decided to rent facilities elsewhere. The land would net $7.4 million if it were sold today. The company now wants to build its new manufacturing plant on this land; the plant will cost $26.5 million to build, and the site requires $1.32 million for an access road to a major highway. What is the proper cash flow amount to use as the initial investment in fixed assets when evaluating this project?

Cash flow 0 year = $7,400,000 + 26,500,000 + 1,320,000 = $35,220,000 The $5.3 million acquisition cost of the land six years ago is a sunk cost. This amount would occur in Kenny, Inc.'s Balance Sheet, but it does not reflect what the land is worth today.

The economic balance sheet

Cashflow generated by firms assets = Cash flows received from investors

Capital Rationing Situations and Process

Companies face two possible capital rationing situations: 1) soft rationing 2) hard rationing. Once the type of rationing has been identified, the next step is to rank the situations. Then, the final step is to determine if the project fits within the capital budget.

Cash Flow and Depreciation "When evaluating projects, we're only concerned with the relevant incremental aftertax cash flows. Therefore, because depreciation is a noncash expense, we should ignore its effects when evaluating projects." Critically evaluate this statement.

Depreciation is not a cash flow and is not relevant for capital budgeting EXCEPT that depreciation is a tax-deductible expense and therefore reduces taxes, which are a cash flow. Thus depreciation causes taxes paid, an actual cash outflow, to be reduced and thus increases the net cash flow. This is the reason that we compute net income and then add back the depreciation expense.A reduction in taxes that would otherwise be paid is the same thing as a cash inflow, so the effects of the depreciation tax shield must be added in to get the total incremental after-tax cash flows.

What are some of the difficulties that might come up in actual applications of the various criteria? Do these difficulties mean that managers can ignore these economic decision techniques?

Estimating cash flows: The single biggest difficulty, by far, is coming up with reliable cash flow estimates. Every company operates in a market environment and is subject to changes in fiscal policies (taxes) and regulations not just for their government, but major governments throughout the world. Technology, consumer preferences and competitive pressures also make cash flow estimates difficult. Estimating opportunity cost: Determining an appropriate discount rate is also not a simple task. Most major governments have an active monetary and exchange-rate policy that affect interest rates. The discount rate is also subject to inflationary pressures. Do we just give up? Even with these difficulties, the economic decision rules of NPV, IRR, and PI provide a useful structure for making decisions in uncertainty. These decision rules helps managers develop their ideas of what information is useful, and provide a structure that can be adjusted as new information is obtained. Not having a decision-making structure exposes managers to ad-hoc, incomplete and uninformed decisions which are likely to produce bad results.

What is the profitability index for the following set of cash flows if the relevant discount rate is 10 percent? Year / CashFlow 0 / -27,500 1 / 15,800 2 / 13,600 3 / 8,300

For PI we would use the calculator to calculate the present value of the INFLOWS ONlY and then divide that result by the initial investment. 1. Enter Initial cash flow (0) Press CFJ 2. Enter Cash flow 1 (15800) Press CFJ 3. Enter Cash flow 2 (13600) Press CFJ 4. Enter Cash flow 3 (8300) Press CFJ 5. Inter discount rate (10) Press I/YR 6. Press downshift then press PRC/NPV The NPV = $31,839.22. PI = (31,839.22 /27,500) = 1.158

Hard Rationing

Funds are not available and managers must choose the best set of projects given their capital constraints. Companies face hard rationing when: - They may not have sufficient retained earnings to finance all profitable projects. - They may not be able to secure additional bank financing. - They might find the capital markets are not receptive to additional security issues.

In the context of capital budgeting, what is an opportunity cost?

In capital budgeting, the opportunity cost is a much broader concept that helps us sort out what is relevant in our capital budgeting decision. In capital budgeting we are not evaluating the entire company. Rather, we are looking as a specific project managers are considering. We must therefore sort out what would change if the project were undertaken—how adopting the project would change the company's cash flows and wealth.

Project Timeline

Initial Cash Flows: Projects initial investment to begin. Projects often take several years of planning and construction before Operating Free Cash Flows appear. There are two types of capital expenditures we should include in initial cash flows: 1) Direct expenditures are those directly connected with obtaining the capital asset. 2) Indirect expenditures which result from our decision to purchase the asset should also be included at the project's inception. Operating Cash Flows: which result from the firm's productive activities. Managerial decisions affect cash flows received and the cash cost of production. The specific nature of these inflows and outflows will depend on the type of project. Revenue enhancing products will focus on cash inflows, cost reduction projects will focus on reducing cash outflows. Terminal Cash Flows: Given the framework of incremental analysis, at the conclusion of a project, management will restore the company to its original condition without the project. There are several types of cash flows connected with closing the project down. (Salvage value, Return of NWC)

Cost reduction. Your firm is contemplating the purchase of a new $410,000 computer-based order entry system. The system will be depreciated straight-line to zero over its five-year life. You will save $125,000 before taxes per year in order processing costs, and you will be able to reduce working capital by $35,000 at the beginning of the project. Working capital will revert back to normal at the end of the project. If the tax rate is 21 percent, what is the IRR for this project?

Initial cash flows: There is a capital cost of -$410,000 at time zero. The reduction in working capital causes an inflow of $35,000, making your initial cash flows (-$410,000) + $35,000 = (-$375,000). next calculate the operating cash flows Terminal cash flows:As the assed is fully depreciated, the only terminal cash flow is the $35,000 return of working capital. 1. enter cash flow 0: -$375,000 Press CFJ 2. Enter cash flow 1: $115,970 Press CFJ 3. Enter 4 Press downshift Press CFJ 4. Enter terminal cashflows for 5th year $80,970 ($115,970 - $35,000) press CFJ 5. Press downshift then press CST/NPV/YR IRR = 14.57%

Cost reduction Kolby's Korndogs is looking at a new sausage system with an installed cost of $655,000. This cost will be depreciated straight-line to zero over the project's five-year life, at the end of which it will have a zero market value. The sausage system will save the firm $183,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $35,000. If the tax rate is 21 percent and the discount rate is 8 percent, what is the NPV of this project?

Initial cash flows: To begin the project Korndogs must invest $655,000 in the new sausage equipment and $35,000 in increased working capital. next calculate the operating cash flows Terminal cash flows: As the project is over, the investment of $35,000 in net working capital is returned to the company in year 5 as well as the last operating cashflow payment. 1. enter cashflow 0: -$690,000 (-$655,000 -$35,000) and press CFj 2. enter all operating cashflows ($172,080) 3. enter terminal cashflows for 5th year $207,080 ($172,080 + $35,000) 4. enter disount rate (8) and pres I/YR 5. Press downshift and press PRC/NPV NPV = $20,886

Net Working Capital (NWC)

Is usually in investment in the beginning of a project but is then later returned at the end of a project. The NWC flows through current assets as the project is running: cash, work in progress, inventory, finished goods, accounts receivable, and back to cash. If a project requires a working capital investment, the firm should account for this as a CASH OUTFLOW. A revenue-increasing project may require additional inventory, more workers, and higher accounts receivable. The company must make these short-term investments to make the project operational. Imagine expanding the production line but not having enough workers! If a project requires a lower working capital investment, the firm should account for this as a CASH INFLOW. With the robotic factory there will be fewer workers. The robots may also be more efficient and not produce as much scrap or fewer imperfect units. Reducing costs by outsourcing production, customer service, and other functions would also reduce the working capital investment.This would cause a cash inflow at time zero.

Capital Budgeting and survivor bias.

Market timing: Companies may enter a market at different times based on several factors. One company may have an existing advantage in that they might have a well-developed supply chain and be able to produce a new product at lower incremental cost. Others may have a strong market presence that may attract customers to something new. Some companies also seem to have a better feel for the movements in consumer interests, or be willing to try a new concept and see how it develops. We may be subject to survivor bias, where we look at the performance of existing companies to gauge the historical performance of all companies. When we look at, say, five very innovative and successful auto companies we may not recall that perhaps ten or fifteen years ago there were a dozen companies with bright prospects. We see the five survivors, but do not see the seven companies that just didn't make it.

Economic Decision Rules

NPV, IRR, PI

Ranking Decision

Regardless of the reason for capital rationing, managers are faced with a special selection process. Managers must rank the projects in order of desirability, pick the best projects, and stop when out of capital. This ranking decision is fundamentally different from that used with mutually exclusive projects. KEY TO REMEMBER: - The ranking decision with mutually exclusive projects was caused by the nature of the projects themselves. - The ranking decision with capital rationing is not due to the nature of the projects, but due to limits on available investment capital.

4 types of capital budgeting projects

Revenue enhancing projects: the company increases revenues more than costs, including both operating and asset investments, producing positive free cash flow. Introduce a new product, improve an existing product, or involve other aspects to increase sales, such as a major marketing campaign. Cost reduction projects: don't change what the company produces, just lowers the costs of production. Outsourcing of business functions, outsourcing production, improving supply chains, employing machine learning and other similar projects lead to lower costs and thus higher income. Corporate Social Responsibility: While the corporation's function in society is to efficiently produce goods and services, corporations are expected to be good citizens. These projects do help society, and also enhance the reputation of the company. Regulatory requirements: Governments regulate economic activity to protect society from harmful effects. These projects are undertaken because they are required.

Capital Budgeting Considerations. A major college textbook publisher has an existing finance textbook. The publisher is debating whether or not to produce an "essentialized" version, meaning a shorter (and lower-priced) book. What are some of the considerations that should come into play?

The 1st is erosion. Will the essentialized book simply displace copies of the existing book that would have otherwise been sold? Text purchasers would just switch from the existing text to the new text. Sales would not increase as much as if an entirely new text, with new customers, were on the offering. This would be of special concern given the lower price. The 2nd consideration is competition. Will other publishers step in and produce such a product? This is very much an issue as publishers are competing more and more with eBooks, such as the one used in our course. A particular concern to book publishers (and producers of a variety of other similar products) is that the publisher only makes money from the sale of new books. Used book dealers capture the revenue streams from the sale of used books: a major reason why new books are so expensive! Thus, it is important to examine whether the new book would displace sales of used books (good from the publisher's perspective) or new books (not good). The concern arises any time that there is an active market for a used product.

Calculating Payback imposing a payback cutoff of three years. Year / CashFlow 0 / -60,000 1 / 23,000 2 / 28,000 3 / 19,000

This project requires an investment of $60,000 today. The first two years have inflows totaling $51,000. Cash flows = $23,000 + 28,000 = $51,000 The cash flows are still short by $9,000 ($60,000 - $51,000) of recapturing the initial investment. As go in to the third year we will make the last $9,000 in ($9,000 / $19,000) = .47 of the year (47% of the third year) The payback for Project A is: Payback = 2.47 years

Capital Budgeting Process

a formal way for managers to guide their capital expenditure decisions. 1. Develop long-term goals - does investment fit the company? - Is the investment economically profitable? 2. Screen Investments - classify the investments as to whether they reduce costs, increase revenues, replace equipment or are required by government regulation. - what is the nature of the investment? - why should it be undertaken? 3. Evaluate Investments - Is the Investment economically profitable? - What're the estimated cashflows? 4. Implement the project - how will the project begin? - how will it be funded? 5. Control - modify the project if benefits, costs, customer demand, taxes or regulations change. - what can potentially change after the project is in place? - will or can it be modified? 6. Audit - how can the capital budgeting process be refined? - how can we make better decisions?

Zayas, LLC, has identified the following two mutually exclusive projects: Year / CashFlow(A) / CashFlow(B) 0 / -78,500 / 78,500 1 / 43,000 / 21,000 2 / 29,000 / 28,000 3 / 23,000 / 34,000 4 / 21,000 / 41,000 a. What is the IRR for each of these projects? b. If the required return is 11 percent, what is the NPV for each of these projects?

a. IRR(A) 1. Enter Initial cash flow (-78500) then press CFj 2. Enter cash flow 1 (43000) and press CFj 3. Enter cash flow 2 (29000) and pres CFj 4. Enter cash flow 3 (23000) and press CFj 5. Enter cash flow 4 (21000) and press CFj To get IRR press downshiftThen CST/IRR to get IRR(A) = 20.70% b. Calculate NPV(A) just enter the discount rate and solve for the NPV, which is $14,426.54. 6. enter 11 and press I/YR 7. Press the downshift key then Press PRC/NPV DO THE SAME FOR OTHER PROJECT

Average Accounting Return (AAR) a. Information and procedures? b. Difficulties with AAR?

a. The average accounting return is interpreted as an average measure of the accounting performance of a project over time, computed as the average net income with respect to average (total) book value. Given some predetermined cutoff for AAR, the decision rule is to accept projects with an AAR in excess of the target measure, and reject all other projects. b. AAR is not a measure of cash flows and market value, but a measure of financial statement accounts that often bear little semblance to the relevant value of a project. In addition, the selection of a cutoff is arbitrary, and the time value of money is ignored. For a financial manager, both the reliance on accounting numbers rather than relevant market data and the exclusion of time value of money considerations are troubling. Despite these problems, AAR continues to be used in practice because (1) the accounting information is usually available, (2) analysts often use accounting ratios to analyze firm performance, and (3) managerial compensation is often tied to the attainment of certain target accounting ratio goals.

Payback Period a. Information and procedures? b. Difficulties with payback? c. Advantages of payback?

a. to actually compute the payback period, it is assumed that any cash flow occurring during a given period is realized continuously throughout the period, and not at a single point in time. For example, while you may be paid at the end of the month, you actually earn income for each day worked. The payback is then the point in time for the series of cash flows when the initial cash outlays are fully recovered. Given some predetermined cutoff for the payback period, the decision rule is to accept projects that payback before this cutoff, and reject projects that take longer to payback. b. the worst problem associated with payback period is that it ignores the time value of money. In not using time value, it also does not use an opportunity cost which would reflect the uncertainty of the cash flows. The payback period is biased towards short-term projects as it ignores any cash flows that occur after the cutoff point. Another drawback is that payback ignores the cash flows that occur, such as the salvage value. c. Despite its shortcomings, payback is often used because the analysis is straightforward and simple. Payback may be sufficient for some small projects that are not of great consequence. Also, projects concerned with maintenance are another example where the detailed analysis of other methods is often not needed. Since payback is biased towards liquidity, it may be a useful and appropriate analysis method for short-term projects where cash management is most important. It may also be used when opportunity cost would be difficult to estimate, such as risky investments in an unstable country,

Independent Projects

are ones when making one choice is independent of other choices. Independent projects involve an accept/reject decision for each project. All projects that are wealth-increasing can be accepted. For example, this month you purchase a refrigerator and a car. Your purchase of a refrigerator is independent of your auto purchase.

fiat money

has no intrinsic value. The word "fiat" is Latin for "order"; in essence, the US government requires its citizens to use the money it creates by declaring that "this note is legal tender for all debts public and private." Fiat money is under the control of the government and can create it without any external constraints. When money is not tied to physical commodities, its purchasing power can vary substantially.

The art of taxation consists..

in so plucking the goose as to procure the largest quantity of feathers with the least possible amount of hissing.

Capital expenses

involve obtaining the major productive asset: a company will pay a substantial amount today to obtain the asset but will use it in its business over the long-term (several years). ex: vehicle

Mutually Exclusive Projects

involves choosing from among alternatives and only picking the best option. Managers rank the projects in order of their desirability and will choose only the top-ranked NPV project. In shopping for a refrigerator, you may visit several stores and look at a dozen refrigerators, but you will end up purchasing only one refrigerator--the one you think is best!

Inflation

is a decrease in the purchasing power of a currency over a given time period. Inflation is more common in modern societies. Central banks, fearing deflation, usually aim for a low, steady rate of inflation, often about 2%. While this doesn't sound like a large rate, over time it can have a major impact on real purchasing power.

Money

is a means of facilitating economic transactions. Three Functions of Money: 1) Exchange - An exchange is where economic assets are traded among buyers and sellers. Money facilitates economic activity in that the price of each economic asset is specified in terms of money. Without money exchange would consist of barter, where the buyer and seller must negotiate a swap of physical goods and services. 2) Prices - Money allows prices to be set for tangible and intangible assets. While we often complain about high prices, we use prices constantly and would not be capable of making comparisons and purchases without a general system of prices. 3) Value - Money traditionally has been a store of value. where wealth (purchasing power) can be stored until needed. If you don't need the purchasing power immediately, then you can just put money in your wallet or purse and spend it later. Storing your wealth in the form of bananas would not be nearly as efficient.

What Is a Cost-Benefit Analysis (CBA)?

is a systematic process that businesses use to analyze which decisions to make and which to forgo. The cost-benefit analyst sums the potential rewards expected from a situation or action and then subtracts the total costs associated with taking that action.

Deflation

is an increase in the purchasing power of a currency over a given time period. deflation is feared by central bankers, as it lowers economic activity by encouraging consumers to delay purchases and increasing the real burden of debt. If prices are expected to drop, then consumers delay their purchases because stuff will be cheaper later. Unfortunately, as sales drop workers are laid off, lowering economic activity. Deflation also makes debt more burdensome.

Free Cash Flow (FCF) / CashFlow From Assets

is the amount of cash generated by a company that is available to distribute to the firm's creditors and owners. This type of cash flow is not needed for short-term (working capital) or long-term (fixed asset) investments and can thus be distributed to the investors—creditors and stockholders—of the firm.

inflation rate

is the rate by which prices are expected to increase due to a loss of purchasing power of money.

The decision rule

is to maximize total NPV while staying within the capital budget.

Incremental Cash Flows

occur only if the project is undertaken. These are structured along the lines of the principles of capital budgeting. - Use cash flows, not accounting revenues and costs. - Take into account the value of the assets used, even if you already possess them. - Include all cash flows that would result from your decision. - Ignore sunk costs. - Use after-tax amounts.

Soft Rationing

occurs when limits on investments are made by a firm's managers for better control of the firm. With soft rationing companies may want to: - Limit growth to a manageable level. The saying is 'growth can kill.' Some companies have had difficulties in growing too fast. They cannot manage the influx of customers, keep quality high, hire enough qualified workers, and overstretch managerial talent. - Existing owners may not want to issue additional financial securities, which might dilute their control of the company.

specie money

physical money made of gold, silver, copper, or other items with intrinsic value. Of its very nature specie is limited in supply and cannot be easily manipulated by a government.

Operating expenses

short-term expenses where the benefits are enjoyed in the same period as the expense are incurred. ex: diesel fuel to run the vehicle on a daily basis.

The Fisher Effect

states that investors who feel that their purchasing power will decrease will demand an increase in the nominal interest rate earned--an INFLATION RISK PREMIUM--in order to give them their required real rate of return. For low rates of inflation capital budgeting analysis is conducted using nominal amounts and rates. If inflation is substantial, managers may do analysis in real, or inflation-adjusted, terms.

Capital rationing

when a company has limited capital and cannot take on all wealth-increasing projects. The company must rank projects and choose the best projects given the capital constraint. This is different from mutually exclusive projects, in that multiple projects can be selected; however, given there is not enough capital to invest in all of the projects, they must be ranked and the projects selected in descending order of desirability. When the money runs out, no more projects may be selected.