Finance II Chapter 14: The basics of capital budgeting

What are the four steps in capital budgeting financial analysis?

1. Estimate expected cash flows 2. Assess riskiness of the flows 3. Estimate appropriate cost of capital discount rate 4. Determine project's profitability and breakeven characteristics.

What are we doing when we're conducting capital budgeting?

1. Estimating our cash flows such as initial cash outlay and operating flows, initial costs, anticipated revenues and terminal flows (the ending cash flow). 2. Assessing the project's riskiness. 3. Estimate the project's cost of capital (opportunity cost, discount rate...) 4. Measure the financial impact; will it be favorable, etc?

What are two other reasons why capital budgeting is used aside from just making decisions about a project's financial impact?

Decisions to divest assets and reduce staffing.

What does failure to invest result in?

Equipment obsolescence and lack of capacity.

What is the most difficult and most critical step in analyzing a project?

Estimating the incremental cash flows that the project will generate.

Should shareholder wealth and the business's financial condition be the only considerations in capital investment projects?

No. NFP's especially should assess their overall impact on the community, and the broader mission of that NFP. Other considerations for both: cost-effective care, increase retention, decrease turnover, staff satisfaction, improved patient outcomes, etc.

In determining incremental cash flows, what costs should be considered?

Opportunity costs must be considered by sunk costs are not included. Also, any impact of the project on the firm's other projects must be included in the analysis.

What is capital investment or capital budgeting a derivative of?

Organizational strategy and/or strategic planning.

What are the two serious deficiencies of payback when it is used as a project selection criterion?

Payback ignores all cash flows that occur after the payback period and it ignores the opportunity costs associated with the capital employed.

For investor owned businesses, financial analysis identifies those projects that are expected to contribute to?

Shareholder wealth

For investor-owned businesses, financial analysis identifies those projects that are expected to contribute to what?

Shareholder wealth

What kind of cost is not included in cash flow analysis?

Sunk costs because they are costs that have already occurred or been irrevocably committed. An example of a sunk cost is hiring and paying a consultant to conduct a marketing analysis on a considered project. The expense on paying the consultant is considered sunk cost and should not be included in the overall cash flow analysis.

How do tax laws affect investor-owned firms?

Taxes reduce a project's operating cash flows, tax laws prescribe the depreciation expense that can be taken in any year and taxes affect a project's salvage value cash flow.

What will happen if a business invests too little in fixed assets?

Technological obsolescence and inadequate capacity.

Capital investment or capital budgeting often involves what?

The acquisition of land, buildings, and equipment.

For not-for-profit businesses, financial analysis identifies a project's expected effect on what?

The business's financial condition

For not for profit businesses, financial analysis identifies a project's expected effect on ?

The business's financial condition.

What is incremental cash flow?

The cash flow with the project minus the cash flow without a project.

What is the internal rate of return?

The discount rate which forces a project's NPV to equal zero, it measures the project's expected rate of return. If the project's IRR is greater than its cost of capital, the project is expected to be profitable and the higher the IRR, the more profitable the project.

What is salvage value?

The expected market value of an asset (project) at the end of its useful life.

What is the net present social value model based on?

The fact that the total value of a project equals its economic value plus its social value.

What is a post-audit?

The feedback process in which the performance of projects previously accepted is reviewed and actions are taken if performance is below expectations.

What is capital budgeting?

The process of analyzing potential expenditures on fixed assets and deciding whether the firm should undertake those investments.

What is the discount rate used called?

The project cost of capital

What are incremental cash flows?

The relevant cash flows to consider when evaluating a new capital investment are the project's incremental cash flows, which are defined as the difference in the firm's cash flows in each period if the project is undertaken versus the firm's cash flows if the project is not undertaken. Incremental CFt= CFt (Firm with project)- CFt (Firm without project). It's typically not feasible to forecast the cash flows of a business with and without a new project. Thus, the actual estimation process focuses on the cash flows unique to the project being evaluated. However, if doubt ever arises as to whether or not a particular cash flow is relevant to the analysis, it is often useful to fall back on the basic definition of incremental cash flow given above.

What is net present value?

The sum of the present values of all the project's net cash flows when discounted at the project's cost of capital. NPV measures a project's expected dollar profitability. An NPV greater than zero indicates that the project is expected to be profitable after all costs, including the opportunity cost of capital, have been considered. The higher the NPV, the more profitable the project.

What are the purposes of a post audit?

To improve forecasts, to develop historical risk data, to improve operations and to reduce losses.

Why do firms often use project scoring?

To subjectively incorporate a large number of factors, including financial and nonfinancial into the capital budgeting decision process.

Project life is usually unknown, so what do we use as an estimate?

5 to 10 years

What is working capital?

A business's short term (current) assets.

What is non-incremental cash flow?

A cash flow that does not stem solely from a project that is being evaluated. Non-incremental cash flows are not included in a project analysis.

What is a sunk cost?

A cost that has already occurred or is irrevocably committed. Sunk costs are non-incremental to project analyses and should not be included.

What is the cost of capital?

A generic term for the cost of a business's financing.

What is net working capital?

A liquidity measure equal to current assets minus current liabilities.

What is project scoring?

An approach to project assessment that considers both financial and nonfinancial factors.

Why might NPV rank a different project higher than IRR?

Because IRR assumes that cash flows can be reinvested at the project's IRR while NPV assumes that cash flows can be reinvested at the project's cost of capital.

What is the best way to consider the effects of inflation into project analysis?

Build inflation effects directly into the component cash flow estimates.

How is project profitability assessed?

By return on investment measures. The two most common are net present value and internal rate of return.

What is the most critical and most difficult step in evaluating capital investment proposals?

Cash flow estimation because it involves estimating the investment outlays, the annual net operating flows expected when the project goes into operation, and the cash flows associated with project termination.

What are the key concepts in cash flow estimation?

Focus on incremental cash flow. Cash flows vs. accounting income (may not reflect movement of cash). Cash flow timing. Project life. Do not include sunk costs because the outlay that has already occurred is unaffected by current decisions. Do include opportunity costs for capital and other resources such as land. Be sure to consider the impact on other business lines; positive or negative (cannibalization). Shipping, installation, and related costs. Inflation effects must be considered. Strategic value implications such as if we move a clinic on the west side of town, maybe we're getting a foothold in a new market or posture the facility to bring in new types of doctors, etc.

What are the disadvantages of payback?

It ignores time value and it ignores all cash flows that occur after the payback period.

What is the net present social value model?

It is a model that formalizes the capital budgeting decision process for not-for-profit firms.

What will happen if a business invests too heavily in fixed assets?

It will have too much capacity and its costs will be too high.

What does the post-audit do?

It's a key element of capital budgeting. By comparing actual results with predicted results, managers can improve both operations and the cash flow estimation process.

What are the advantages of payback?

It's easy to calculate and understand and it provides an indication of a project's risk and liquidity.

How is time breakeven measured and what does it do?

It's measured by the payback period and it provides managers with insights concerning a project's liquidity and risk.

What is depreciation expense?

It's not a cash flow but an accounting convention that amortizes the cost of a fixed asset over its revenue producing life.

What is the modified internal rate of return?

It's the rate of return which forces a project's cash flows to be reinvested at the project's cost of capital, it's a better measure of a project's percentage rate of return than the IRR.

What differentiates the MIRR from the IRR?

MIRR uses FV of cash flows and calculates the rate of return required to equal the PV of the investment.

What are some types of project classifications?

Mandatory replacement Discretionary replacement Expansion of existing services or markets Expansion into new services or markets Environmental projects