Study Unit 8 - Capital Budgeting Process

Disadvantages of payback method

- Disregarding all cash inflows after the payback cutoff date. - Disregarding the time value of money

Disadvantages of Discounted payback method

- Disregarding all cash inflows after the payback cutoff date. - it losses the simplicity of the traditional payback method.

Notes on profitability index

- If the NPV is positive and funds is limited, pick the highest profitability index. The high profitability index means that the company will achieve the highest NPV per dollar of investment - The profitability index facilitates comparison of different-sized investments. - If profitability index > 1 = project must be accepted - If profitability index < 1 = project must be rejected

Notes on Capital Budgeting

- Relevant cash flows are a much more reliable guide when judging capital projects because only they provide a true measure of a project's potential to affect shareholder value. - Post-audits should be conducted to serve as a control mechanism and to deter managers from proposing unprofitable investments. - The net present value (NPV) method expresses a project's return in dollar terms - The internal rate of return (IRR) expresses project's return in percentage terms - The payback reciprocal (1 ÷ payback) has been shown to approximate the internal rate of return (IRR) when the periodic cash flows are equal and the life of the project is at least twice the payback period.

Notes on IRR (Internal rate of return)

- The IRR of an investment is the discount rate at which the investment's NPV equals zero. - it is the rate that makes the present value of the expected cash inflows equal the present value of the expected cash outflows. - If the IRR is higher than the company's desired rate of return, then the investment is desirable - The IRR is also the maximum borrowing cost the firm can afford to pay for a specific project.

Notes on bailout payback method

- The bailout payback period is the length of time required for the sum of the cumulative net cash inflow from an investment and its salvage value to equal the original investment. - The bailout payback method measures the risk to the investor if the investment must be abandoned. - The shorter the period, the lower the risk

General notes

- When faced with capital rationing, an investor will want to invest in projects that generate the most dollars in relation to the limited resources available and the size and returns from the possible investments. Thus, the NPV method should be used because it determines the aggregate present value for each feasible combination of projects. - When cash flows of a project change sign more than once, there will be multiple IRRs; in these cases, NPV is the preferred measure. - Net present value (NPV) is the most satisfactory method of evaluating competing capital projects. - The method of funding a project is a decision separate from that of whether to invest. this is not a consideration in the calculation of the net present value. - The IRR is also the maximum borrowing cost the firm could afford to pay for a specific project. The IRR is similar to the yield rate/effective rate quoted in the business media. - A hurdle rate is not necessary in calculating the accounting rate of return. That return is calculated by dividing the net income from a project by the investment in the project. Similarly, a company can calculate the internal rate of return (IRR) without knowing its hurdle rate. The IRR is the discount rate at which the net present value is $0. However, the NPV cannot be calculated without knowing the company's hurdle rate. The NPV method requires that future cash flows be discounted using the hurdle rate. - The NPV method assumes that the cash flows are reinvested at the desired rate of return, not at the cost of capital. - An increase in the discount rate would lower the net present value, as would a decrease in cash flows or an increase in the initial investment. - The IRR is also the maximum borrowing cost the firm can afford to pay for a specific project. - accounting rate of return is also called the unadjusted rate of return or book value rate of return - profitability index provides an optimal ranking in the absence of capital rationing. - The profitability index (excess present value index) facilitates the comparison of investments that have different initial costs. - The usual payback formula divides the initial investment by the constant net annual cash inflow. The payback method is unsophisticated in that it ignores the time value of money, but it is widely used because of its simplicity and emphasis on recovery of the initial investment. - If it is a mutually exclusive project, only one project is selected. - The high profitability index means that the company will achieve the highest NPV per dollar of investment - All relevant costs should be considered when evaluating an equipment-replacement decision. These include the cost of the new equipment, the disposal price of the old equipment, and the operating costs of the old equipment versus the operating costs of the new equipment. The original cost or fair market value of the old equipment is a sunk cost and is irrelevant to future decisions. - A tax shield is something that will protect income against taxation. Thus, a depreciation tax shield is a reduction in income taxes due to a company's being allowed to deduct depreciation against otherwise taxable income. - Net present value (NPV) is the most satisfactory method of evaluating competing capital projects.

Real options

- are alternatives or choices that become available over the life of a capital investment. - are not measurable with the same accuracy as financial options because the formulas applicable to the latter may not be appropriate for the former.

Advantage of Internal capital market

- avoidance of stock issue costs or interest costs on new debt.

bailout payback method

- incorporates the salvage value of the asset into the calculation - It measures the length of the payback period when the periodic cash inflows are combined with the salvage value - This method measures risk

profitability index (or excess present value index)

- is a method for ranking projects to ensure that limited resources are placed with the investments that will return the highest NPV. = PV of future cash flows / Net investment

annuity due (annuity in advance)

- is a series of payments at the BEGINNING of each period. - first payment is not discounted and interest is earned on the first payment

ordinary annuity (annuity in arrears)

- is a series of payments occurring at the END of each period - first payment is discounted and interest is not earned for the first period of an annuity.

Internal capital market

- is a way of referring to the provision of funds by one division of a firm to another division.

discounted payback method (break-even time),

- is sometimes used to overcome the second of the drawback (w/c is not considering the time value of money) inherent in the basic payback method - more conservative technique than the traditional payback method.

Risk tolerance

- is the acceptable degree of variability in returns

certainty equivalent

- is the guaranteed return that a company would accept over taking a risk on a higher, but uncertain return - specifies at what point the company is indifferent to the choice between a certain sum of money and the expected value of a risky investment.

payback period

- is the number of years required to return the original investment, that is, the time necessary for a new asset to pay - Initial net investment / Annual expected cash flow

Annuity

- is usually a series of equal payments at equal intervals of time. Note: Annuity can either be PV or FV

Advantages of Discounted payback method

- it considers the time value of money

Advantages of payback method

- simplicity - Since it measures the period of the investment, management can assume that the longer the period the more risky the investment is. - it roughly estimates the liquidity of the investment by knowing the investment period.

Disadvantage of Internal capital market

- the word market is somewhat misleading considering that the process is more centralized that to the workings of a free marketplace.

Types of real options

1. Abandonment of a project - the entity determines that the abandonment value of a new or existing project exceeds the NPV of the project's future cash flows. 2. Delay - allow the option holder to postpone a project without losing the opportunity 3. Expand - to move forward with or expand a project after the initial stage has been implemented. 4. Scale back - to shrink a project after the initial stage has been implemented. 5. Flexibility option to vary inputs 6. Capacity option to vary output - respond to economic conditions 7. Option to enter a new geographical market - NPV is apparently negative but the follow-up investment option is promising 8. New product option - to sell a complementary or a next-generation product even though the initial product is unprofitable.

Steps in Ranking Potential Investments

1. Determine the asset cost or net investment 2. Calculate estimated cash flows 3. Relate the cash flow benefits to their costs 4. Rank the investment

Factors that reduce the usefulness of IRR

1. Direction of cash flows - When the direction of the cash flows changes, focusing simply on IRR can be misleading 2. For mutually exclusive projects - As with changing cash flow directions, focusing only on IRR when capital is limited can lead to unsound decisions. 3. IRR is limited to single summary rate for the entire project 4. For multiple investments - The IRR for the whole is not the sum of the IRRs for the parts.

Stages in Capital Budgeting

1. Identification and definition - identifying the program/project the firm is planning to invest to and establishing the objectives it needs to attain. 2. Search - preliminary analysis of the potential investments and its impact among other functions in the value chain. 3. Information-acquisition - detail listing of cost and benefits after passing the search phase. 4. Selection - selecting the best model for the calculation of the return on the investment. This model should include both financial and nonfinancials analysis of the return. 5 Financing - deciding as to what will be the source of funding for this investment. 6. Implementation and monitoring - once the project is implemented, progress must be monitored and variances must be analyzed.

Differences between NPV model and IRR model

1. NPV and IRR may rank mutually exclusive projects differently if for example the projects have different useful lives. 2. NPV can easily be determined using different desired rates of return for different periods whereas IRR determines one rate for the projects. 3. For multiple investments involved in a projects, NPV amounts are addable while IRR rates are not.

Costs to consider in Capital budgeting analysis

1. Relevant cost - are avoidable cost and may be eliminated by ceasing an activity or by improving efficiency. 2. Incremental cost - is the increase in total cost resulting from selecting one option instead of another. 3. Irrelevant costs - do not vary between different alternatives and therefore do not affect the decision. a. Sunk cost - is irrelevant because it has already been incurred and cannot be changed. b. Committed cost - is a cost that will be incurred in the future due to previously made decisions.

Reasons for Capital rationing

1. lack of nonmonetary resources 2. desire to control estimation bias 2. unwillingness to issue new equity

FV annuity calculation

1. ordinary annuity (annuity in arrears): Payment received (for the period) x FV factors (i.e. based on the FV table: # of period payments & its corresponding factor) 2. annuity due (annuity in advance) a. First, select the FV factor: (# of periods of payments + 1) = then pick the factor in correspond to the net # of periods. b. results in # a - 1 c. Payment received (for the period) x results in # b

PV annuity calculation

1. ordinary annuity (annuity in arrears): Payment received (for the period) x PV factors (i.e. based on the PV table: # of period payments & its corresponding factor) 2. annuity due (annuity in advance) a. First, select the PV factor: (# of periods of payments - 1) = then pick the factor in correspond to the net # of periods. b. results in # a + 1 c. Payment received (for the period) x results in # b

Payback reciprocal

= 1 / payback - is sometimes used as an estimate of the internal rate of return.

Project termination cash flow

= After tax proceeds from the disposal (e.g. the salvage value of the property x [1-tax rate]) + Initial working capital requirement (i.e. either increase in AR or Inventory or both) Note: Calculation of after tax proceeds: [Disposal Value (e.g. salvage value) - Tax basis] x 1-tax rate

Annual net cash flow

= Annual cash collection (i.e. expected revenue from the investment) - Income tax expense (i.e. revenue x tax rate) + tax savings on the depreciation deduction (i.e. [value of the new equipment under initial investment / life of the investment] x tax rate) Note: 1. The life of the depreciation is not the life of the property but rather the life of the investment. 2. Salvage value of the property is not deducted in the calculation of the depreciation.

Net initial investment

= Initial outlay (e.g. purchase of new equipment) - Initial working capital requirement (i.e. either increase in AR or Inventory or both) + After tax proceeds from the disposal of old equipment NOTE: Calculation of after tax proceeds: 1. Determine the gain or loss of the equipment: Disposal value (i.e. cash received) - Tax basis (i.e. book value of the asset) = gain/loss 2. After tax proceeds: Assume it is a loss: Disposal value (i.e. cash received) + tax savings on the loss (i.e. loss x tax rate). Assume it is a gain: Disposal value (i.e. cash received) - tax paid on the gain (i.e. gain x tax rate)

3 categories of relevant cash flow

NAP 1. Net initial investment 2. Annual net cash flows 3. Project termination cash flow

Capital rationing

exists when a firm sets a limit on the amount of funds to be invested during a given period

Linear programming

is a technique (now usually computerized) for optimizing resource allocations so as to select the most profitable or least costly way to use available resources

Future value (FV) - single amount

is the amount available at a specified time in the future based on a single investment (deposit) today.

Net cash flow

is the economic benefit or cost, period by period, resulting from the investment.

opportunity cost

is the maximum benefit forgone by using a scarce resource for a given purpose and not for the next-best alternative.

hurdle rate

is the minimum rate of return on a project or investment that an investor is willing to accept.

Depreciable life

is the period used for accounting and tax purposes over which cost is to be systematically and rationally allocated

Capital budgeting

is the process of planning and controlling investments for long-term projects.

Economic life

is the time period over which the benefits of the investment proposal are expected to be obtained, as distinguished from the physical or technical life of the asset involved.

Present value (PV) - single amount

is the value today of some future payment

Accounting rate of return (also called the unadjusted rate of return or book value rate of return)

measures investment performance by dividing the accounting net income by the average investment in the project. Note: This method ignores the time value of money.