Corporate Finance: Capital Budgeting

disadvantages of IRR

- conflicting project rankings, different than NPV method - possibility for multiple IRR's or no IRR on projects

key advantage of NPV

- it is a direct measure of expected increase in firm value - main weakness: does not consider size of project

key advantage of IRR

- measures profitability as percentage, showing return on each dollar - provides info on margin of safety (how low project return can fall before NPV is negative)

net present value (NPV)

- sum of PVs of all expected incremental cash flows in a project is undertaken - discount rate = firm's cost of capital - for independent projects, accept any project with an NPV greater than zero

5 key principles of capital budgeting process

1. decisions based on cash flows, not accounting income 2. cash flows based on opportunity cost 3. timing of cash flows is important 4. cash flows analyzed on after-tax basis 5. financing costs reflected in project's required rate of return

4 administrative steps of capital budgeting process

1. idea generation 2. analyzing project proposals (decision to accept/reject) 3. create firm-wide capital budget 4. monitoring decisions and conducting post-audit

profitability index (PI)

PV of project's future cash flows divided by initial cash outlay - if PI > 1 (so NPV > 0), accept project - if PI < 1 (so NPV < 0), reject the project

opportunity cost

cash flows the firm will lose by undertaking the project under analysis - ex: if firm already owns land, it is still a cost because without the project they could sell it - should be included in project costs

conventional vs unconventional cash flow pattern

conventional: sign changes once - one or more cash outflows followed by series of inflows unconventional: more than one sign change (outflow then inflow then outflow, etc)

sunk costs

costs that cannot be avoided, even if project is not undertaken - not included in analysis (do not affect accept/reject decision)

internal rate of return (IRR)

discount rate that makes the PV of the expected incremental after-tax cash flows just equal to initial cost of project - discount rate that makes NPV = zero - makes PV(inflows) = PV(outflows) - accept project if IRR > required ROR

crossover rate

discount rate where NPV profiles intersect on x axis - where NPVs = zero

NPV profile

graph that shows project's NPV for different discount rates

cannibalization

negative externality - occurs when a new project takes sales from an existing product

discounted payback period

number of years it takes a project to recover initial investment in PV terms - must be greater than payback period - still does not consider cash flows beyond PBP, so primarily measure of liquidity

payback period (PBP)

number of years it takes to recover the initial cost of an investment - main drawback: does not consider TVM/cash flows beyond PBP (ex salvage value) -- useless as profitability measure - main benefit: good measure of project liquidity

mutually exclusive projects

only one project in a set of possible projects can be accepted; the projects compete with each other

independent projects

projects that are unrelated to each other and allow for each project to be evaluated based on its own profitability

incremental cash flows

relevant cash flows to consider as part of the capital budgeting process changes in cash flows that will occur if project is undertaken

externalities

the effects the acceptance of a project might have on other firm cash flows

capital budgeting process

the process of identifying and evaluating capital projects (projects where the cash flow to the firm will be received over a period longer than one year)