Financial Decision Models

Rate of return desired for project

Management may use a WACC method, a specific target rate assigned to new projects, or a rate that related to the risk specific to the proposed project. If the proposed project is similar in risk to the ongoing projects of the company, WACC is appropriate because it reflects the market's assessment of the average risk of the company's projects

Capital Rationing with Limited Capital

Managers will allocated capital to the combination of projects with the maximum NPV.

Capital Budegting

Process for evaluating and selecting long-term investment projects of the firm

Investment decision when IRR < Hurdle Rate

Reject

Operating lease

Similar in concept to a finance lease, but does not meet OWNES criteria

Calculation of NPV

1) Calc after tax cash flows = annual net cash flow x (1-tax rate) 2) add depreciation benefit = depreciation x tax rate 3) multiply result by appropriate PV of an annuity 4) subtract initial cash outflow

Two decisions relating to leases

1) Investment decision 2) Financing decision

Limits of IRR

- Unreasonable Reinvestment Assumptions - Inflexible cash flow assumptions - Evaluates alternatives based entirely on interest rates

Advantages to payback method

- easy to use and understand - emphasis on liquidity

Interest rate adjustments for required return

- risk - inflation

Limits of payback method

- time value of money is ignored - project cash flows occurring after the initial investment is recovered are not considered - reinvestment of cash flows is not considered - total project profitability is neglected

Financial Statement Implications of a Finance Lease

A ROU asset and lease liability will be recognized on the balance sheet of the lessee. Debt-to-equity would initially rise. Lease payments split between interest expense and repayment of principal, therefore liability is amortized over time and eventually falls to zero. Interest expense in early years is relatively high, decreasing interest coverage ratio, but interest expense falls as time goes on

Discount Rate Applied to Qualitatively Desirable or Non-optional Investments

A project that meets qualitative management criteria for investment is subject to financing, rather than capital budgeting. In this case, the discount rate used for NPV evaluation should be the after-tax cost of borrowing, sometimes called the incremental borrowing rate

Investment decision when IRR > Hurdle Rate

Accept

Financial Statement Implications of borrowing to buy

Bank loan will be recorded in non-current liabilities and will increase firm's debt-to-equity ratio. Interest on debt will reduce the firm's interest coverage ratio. Overall effect, also depends on profits generated by the asset as these will increase earnings and equity

Stages of Cash Flows: Inception of the project (time period zero)

Both direct cash flows (acquisition cost of asset) and indirect cash flows (working capital requirements or disposal of replaced asset). The initial cash outlay for the project is often the largest amount of cash outflow of the investment's life. When a capital project is implemented, the firm may need to increase or decrease working capital to ensure success of the project

Limitation of DCF

They frequently use a single interest rate assumption. This assumption is often unrealistic because as management evaluates alternatives, actual interest rates or risks may fluctuate

Payback period method

Time required for the net after-tax operating cash inflows to recover the initial investment in a project = Net initial investment / Average incremental cash flow

Limits of the NPV method

Considered the best single technique for capital budgeting, but does not provide the true rate of return on the investment

What key ratios are particularly affected by the lease vs buy decision?

Debt-to-Equity ratio and interest coverage ratio

Investment decision of leases

Does the asset give operational benefits? Focus on the NPV of the after-tax operating cash inflows. Discount cash flows using a rate which reflects the operating risk of investment Discount after-tax operating cash inflows at the firm's WACC

Capital rationing

How limited investment resources are considered as part of investment ranking and selection decisions

Interpreting NPV method

If NPV = 0, management is indifferent. NPV is the theoretical dollar change in the market value of the firm's equity due to the project. Positive result = make investment, Negative result = do not make investment

Stages of Cash Flows: Disposal of the project

If asset is sold, there is a direct effect for cash inflow and indirect effect for taxes due (in case of a gain) or saved (in case of a loss). Certain direct expenses may be incurred for the disposal. If the asset is scrapped or donated, there may be a tax savings if the net tax basis is greater than zero (the asset had not been fully depreciated). A working capital commitment that was recognized as an indirect cash outflow at inception is recognized as an indirect cash inflow at the end of the project when the working capital commitment is released. Year of disposal will include these cash flows AND the last year of operating cash flows

In what investment scenario will the reduced working capital requirements at inception?

Implementing a JIT inventory system represents a decrease in current assets and is recognized as an indirect cash inflow

Capital Rationing with Unlimited Capital

Investments undertaken in order they are ranked. All investment alternatives with a positive NPV should be pursued

Financing decision of leases

Is it cheaper to buy or lease? Focus on relative benefits of tax allowable depreciation from buying versus tax savings from the lease payments. Discount these cash outflows using the after-tax cost of debt. Preferred financing option is that with lowest NPV Buying asset relevant cash flows: - purchase cost /PV of lease payments - tax savings from depreciation - scrap proceeds Leasing asset relevant cash flows: - lease payments - tax savings on lease payments

Direct cash flow effect

When a company pays out cash, receives cash, or makes a cash commitment that is directly related to the capital investment

In what investment scenario will there be additional working capital requirements at inception?

When the proposed investment is expected to increase payroll, expenses for suppliers, or inventory requirements. This may result in an indirect cash outflow that is recognized at the inception of the project because part of the WC of the org will be allocated to the investment project and unavailable for other uses in the org

The method that recognizes the time value of money by discounting the after-tax cash flows over the life of a project, using the company's minimum desired rate of return:

net present value method

Profitability Index

Also called the excess present value index, or simply the present value index. When over 1, means that the PV of inflows is greater than the PV of outflows. Measures cash-flow return per dollar invested. = Present value of cash flows / Cost (present value) of initial investment Higher the better. Limited capital resources are applied in order of the index

Financial Statement Implications of an Operating Lease

An entity may elect not to recognize an asset and liability if the lease is 12 months or less and there are no purchase options associated with the lease that the lessee is reasonably certain to exercise. Otherwise, similar to borrow to buy and finance lease implications

Finance lease

Analogous to a lessee buying an asset and financing it with debt. Meets at least one of OWNES criteria

What are the two types of inflows when disposing of a replaced asset?

Asset abandonment, where the net salvage value is treated as a reduction of the initial investment of the new asset. Book value is a sunk cost and not considered. Tax book value is deductible as a tax loss, which reduces the liability in the year of abandonment. Asset sale, where cash received from sale reduces investment's value. If a gain or loss exists for tax purposes, there is a corresponding increase or decrease in income taxes. Amount of income tax paid on gain is treated as a reduction of sales price (which increases initial expenditure), and tax resulting from a loss is treated as reduction on the new investment.

Stages of Cash Flows: Opeations

Cash flows will be generated from operations of the asset on a regular basis. These cash flows may be the same amount each year (like an annuity) or differ. Depreciation tax shields create ongoing indirect cash flow effects.

Discounted Payback Method

Computes the payback period using expected cash flows that are discounted by the project's cost of capital (considers time value of money, and also referred to as the breakeven time method)

Advantages of the NPV method

Flexible and can be used where there is no constant rate of return required for each year of the project

Objective of the NPV Method

Focus decision makers on the initial investment amount that is required to purchase (or invest in) a capital asset that will yield returns in an amount in excess of a management-designated hurdle rate Requires managers to evaluate the dollar amount of return instead of percentages or years.

Objective of Discounted Cash Flow in Capital Budgeting

Focus the attention of management on relevant (after tax) cash flows appropriately discounted to present value

Objective of payback period

Focuses decision makers on liquidity and risk. The greater the risk of the investment, the shorter the payback period that is expected (tolerated) by the company

The discount rate is determined in advance for which of capital budgeting technique?

Net present value

Indirect cash flow effect

Noncash activity that produces cash benefits or obligations (like depreciation, because of the associated tax deduction)