Finance chapter 8

Steps of capital budgeting process

1) Estimate project cash flows and opportunity cost of capital 2) Financial analysis and project selection using many of the project evaluation techniques 3) Project implementation 4) Project review- Post-audit -A comparison of actual results to those projected in the request for funds -An explanation of observed differences

Profitability index method steps

1) Forecast cash flows 2) Estimate opportunity cost of capital 3) Calculate the PI for each project 4) Rank projects by the PI and go down the list until you either run out of $$ or exhaust all projects with a PI greater than 0

IRR method steps

1) Forecast cash flows (amount and timing of each) 2) Estimate the opportunity cost of capital 3) Set up net present value formula and equate to zero with the appropriate discount rate being sole unknown. 4) Project decision

NPV steps

1) Forecast cash flows (amount and timing of each) 2) Estimate the opportunity cost of capital (i.e. estimate required rate of return for projects of similar risk level) 3) Use the opportunity cost of capital to discount future cash flows 4) Project decision

Cons to IRR method

Borrowing/ lending problem, multiple irr or no- IRR, mutually exclusive projects

Pros of PI method

Closely related to NPV, easy to communicate and understand, useful when available investment funds are limited

Equivalent annual cost

Cost per period with the same present value as the cost of buying and operating the machine

Mutually exclusive projects IRR

Different scales, different time horizons

Good decision criteria

Does the decision rule take into account all relevant cash flows? Does the decision rule adjust for time value of money? Does the decision rule adjust for risk?

Payback period

Expected number of years required to recover a project's initial investment

IRR rule

Go ahead with project if the IRR is greater than the opportunity cost of capital

NPV rule

Go ahead with the project if the present value of cash flows is greater than the present value of cash outflows, NPV>0 Managers increase shareholders' wealth by accepting all projects that are worth more than they cost after accounting for time value of money

NPV question

How much value is created from undertaking an investment?

Borrowing/lending problem

IRR rule does not differentiate between whether you are getting the rate or paying the rate

Payback period cons

Ignores time value of money, ignores cash flows occurring after the payback period

Capital budgeting

Investment decisions in long-term assets (tangible or intangible)

Cons of PI method

May lead to incorrect decisions in comparisons of mutually exclusive investments

Profitability index method

Measures the benefit per unit cost, based on the time value of money This measure can be very useful in situation where the firm has limited capital (capital rationing)

Internal rate of return method (IRR)

Most important alternative to NPV It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere

What would be a good rule for managers to follow when choosing investments?

NPV measures each project's contribution to shareholder wealth Favored because it focuses on building shareholder wealth

Profitability index

NPV of project cash flows divided by the initial investment

Project evaluation techniques

Net present value, Internal rate of return, modified internal rate of return, profitability index, payback period

Unconventional cash flows

Nothing to worry about- same procedure still applies

Most common method in small companies

Payback period

Type of capital budgeting projects

Replacement of existing assets, expansion of existing products or services, entry into new products/markets, mandated projects

EAC rule

Select machine with lowest EAC

Uses of capital budgeting rules in very small companies

Survey data, firm < 250 employees 30% do not estimate cash flows, 26% do not take taxes into account Common: "gut feel" (26%), and payback (19%) 14% use discounted cash flow based models High growth, younger, and larger firms are more likely to make cash flow projections and use DCF

IRR

The discount rate which equates the PV of a project's cash inflows to the present value of its cash outflows -The return that makes NPV=0

EAC intuition

The level annual charge necessary to recover the PV of investment outlays and operating costs

Multiple IRR or no IRR problem occurs when

There is more than one period, sign change in cash flows

Uses of capital budgeting rules in large companies

Traditionally IRR has been the most popular budgeting technique among fortune 1000 firms Over the years, NPV has grown and is now the most popular technique among fortune 1000 firms

Usefulness

Use when trying to decide between two or machines that do the same job, but have different useful lives -Assumes that the machines will be replaced when they wear out

Firms with younger, more educated owners are more likely to

plan and use DCF

NPV of a project

the present value of its cash flows, discounted at the opportunity cost of capital -Difference between the PV of cash inflows and cash outflows of the project