Bus1B Ch 11 Capital Budgeting and Investment Analysis

discounting

restating future cash flows in terms of their present value

If a company uses straight-line depreciation, the annual average investment can be calculated as: (Check all that apply.)

(beg book value + salvage value)/2. sum of individual years' avg book values/number of years of planned investment (beg book value + end book value)/2.

annuity

Series of equal cash flows or payments at equal intervals.

2 step process to get Internal rate of return with even cash flows

Step 1. Compute present value factor for the investment project. Step 2. Identify the discount rate (IRR) yielding the present value factor. Search table B3

Which of the following are correct statements about the internal rate of return? (Check all that apply.)

- The higher the IRR, the better. - IRR reflects the time value of money.

The advantages of a postaudit include (select all that apply):

- managers will be more careful in proposals they submit - poor investments can be identified early

factors than can complicate NPV analysis include

- unequal cash flows - salvage value - accelerated depreciation - inflation - comparing positive NPV projects - capital rationing

a capital budgeting decision is risky because

1) the outcome is uncertain (2) large amounts of money are usually involved (3) the investment involves a long-term commitment (4) the decision could be difficult or impossible to reverse, no matter how poor it turns out to be. --Risk is especially high for investments in technology due to innovations and uncertainty.

Capital investment cash flow

1. Acquisition: (-) Initial investment 2. Use: (+) Revenues, (-) Operating costs, (-) Repairs and maintenance 3. Disposal: (+) Disposal proceeds

3 steps of Capital Budgeting Process:

1. Department or plant manager submits proposals. 2. Capital budget committee evaluates proposals. 3. Board of directors approves capital expenditures.

Payback period has three major weaknesses:

1. Does not reflect differences in the timing of net cash flows. 2. Ignores all cash flows occurring after the point where an investment's costs are fully recovered. 3. Ignores the time value of money.

Accounting rate of return has three major weaknesses:

1. Ignores time value of money. 2. Focuses on income, not cash flows. 3. If income varies each year, project may appear desirable in some years and not in others. --SHOULD NEVER BE THE ONLY CONSIDERATION

Benefits of a postaudit include:

1. Managers will be more careful in the investment proposals submitted. 2. Poor investments can be identified earlier and management can change its investments.

2 capital budgeting methods using time value of money

1. Net present value (NPV) 2. Internal rate of return

2 methods of investment analysis without using time value of money

1. Payback period 2. Accounting rate of return

Payback period has two strengths:

1. Uses cash flows, not income. 2. Easy to use.

cumulative total of net cash flows

1. find where cumulative net cash flow changes from negative to positive (- YrA to + YrB) 2. If the negative cumulative net cash flow at YrA is X and the expected NET cash flow during YrB is Y. 3. The payback period would be A+[X/Y]

Annual average investment (SL only) =

= [Beg book value + End book value] /2 --Ending book value is salvage value if applicable --higher = better

accounting rate of return (ARR) =

= after-tax periodic net income / annual avg investment in the asset

payback period (PBP) with even cash flow =

= cost of investment / annual net cash flow

Net present value =

= discounting future cash flows from the investment at a satisfactory rate - initial cost of investment.

Annual average investment (general) =

= sum of individual yrs' avg book values / # of yrs of planned investment

Net present value (NPV)

Dollar estimate of an asset's value that is used to evaluate the acceptability of an investment

capital rationing

Financing constraints that limit firms from accepting all positive net present value projects.

Investment rule with IRR

If IRR>predetermined hurdle rate, invest

investing rule using NPV

If NPV>$0, invest

Hurdle rate

Minimum acceptable rate of return (set by management) for an investment. --typically its cost of capital

A company is considering two investment projects. Both have an initial cost of $50,000. One project has even cash flows and the other uneven cash flows. Which evaluation method would be most appropriate?

Net present value

profitability index =

Present value of NET cash flows for a project / initial investment amount.

cost of capital

Rate the company must pay to its long-term creditors and shareholders.

accounting rate of return (ARR)

Rate used to evaluate the acceptability of an investment; also called rate of return on average investment. -- called "accounting" return b/c based on NET INCOME, not cash flow!

internal rate of return (IRR)

Rate used to evaluate the acceptability of an investment; equals the rate that yields a net present value of zero for an investment.

payback period (PBP)

Time-based measurement used to evaluate the acceptability of an investment; equals the time expected to pass before an investment's net cash flows equal its initial cost. --Managers prefer investing in assets with shorter payback periods to reduce the risk of an unprofitable investment over the long run.

Break even time (BET)

Time-based measurement used to evaluate the acceptability of an investment; equals the time expected to pass before the present value of the net cash flows from an investment equals its initial cost.

Instead of forecasted cash flows, the postaudit uses ______ cash flows (for periods that have passed) and ______ future cash flows.

actual; revised

Present value factor w/ even CF =

amount invested / annual net cash flows

postaudit

an evaluation of a project's actual results vs projected results --same method in capital budgeting decision is used here

Hard rationing

capital rationing imposed by external forces (ex. debt covenants that restrict firm's ability to borrow)

soft rationing

capital rationing internally imposed by management and board of directors (ex. spending limit set on dept or employees until good records are demonstrated)

net cash flow =

cash inflows - cash outflows

compute payback period with uneven cash flows using the ... method

cumulative total of net cash flows

NPV =

discounted future net cash flows - initial investment

Depreciation does not affect cash so ...

it is not included in net cash flow and may be added back to net cash flow from net income

Nearly all of the evaluation methods used by managers for capital budgeting decisions involve...

predicting future cash inflows and cash outflows of proposed investments, assessing the risk of and returns on those cash flows, and then choosing the investments to make.

profitability index

relation between expected project benefit and its investment --1+ is more desirable

A company is considering several investment opportunities. The investments have been evaluated using payback period and break-even time. Only one project will be chosen and time value of money is important. The company should choose the project which the:

shortest break-even time

It is appropriate to use the profitability index to evaluate investment decisions when:

the amounts invested differ substantially

capital budgeting

the process of analyzing alternative long-term investments and deciding which assets to acquire or sell. ex. buying machinery/building/company -- objective is to earn a satisfactory return on investment