Capital Budgeting

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1. capital budgeting decision whether to invest in project/acquire assets/pro-

decision duce a product

2. General Steps for 1. Estimate cash flows

Capital Budget- 2. estimate required rate of return
ing 3. apply a decision rule to accept or reject a project

3. net present value the sum of the present values of expected future cash
(NPV) flows from an investment minus the cost of that invest-
ment; difference between an investment's market value
and its cost

4. net present value An investment should be accepted if the net present value
rule is positive and rejected if it is negative.

5. NPV formula

6. advantages of 1. properly accounts for time value of money

NPV 2. always gives correct decision

7. disadvantages of need to know the correct discount rate/relevant risk of

NPV project to get NPV

8. If the NPV is 0, yes, they made the required rate of return

did the firm make
any return on the
project?

9. payback the length of time it takes to recover initial investment

10. payback rule an investment is acceptable if its calculated payback peri-

od is less than some prespecified number of years

11. Advantages of 1. Easy to understand

Payback Rule 2. Adjusts for uncertainty of later cash flows (by ignoring
them)
3. Biased toward liquidity

12. Disadvantages of 1. Ignores time value of money

Payback Rule 2. Requires arbitrary cutoff point
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3. ignores cash flows beyond the cutoff date
4. Biased against long term projects

13. discounted pay- the length of time until the sum of the discounted cash
back period flows is equal to the initial investment

14. discounted pay- Based on the discounted payback rule, an investment is

back rule acceptable if its discounted payback is less than some
prespecified number of years.

15. NPV of project must be positive

that pays back on
discounted basis

16. advantages of 1. includes time value of money

discounted pay- 2. easy to understand
back rule 3. does not accept negative estimated NPV investments
4. biased toward liquidity

17. disadvantages of 1. may reject positive NPV investments

discounted pay- 2. requires arbitrary cutoff
back rule 3. ignores cash flows beyond cutoff date
4. biased toward longterm projects

also not commonly used in practice because it's not sim-

pler than just doing the NPV calculation

18. Average Ac- an investment's average net income divided by its average
counting Return book value
(AAR)

19. average account- a project is acceptable if its average accounting return

ing return rule exceeds a target average accounting return

20. Advantages of 1. Easy to calculate

AAR 2. Needed information will usually be available

21. Disadvantages of 1. Not a true rate of return; time value of money is ignored
AAR 2. Uses an arbitrary benchmark cutoff rate

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3. Based on accounting net income and book values, not
cash flows and market values

22. conventional se- one initial outflow, then all inflows

ries of cash flows

23. internal rate of the discount rate that makes the NPV of an investment
return (IRR) zero; the discount rate that one would choose to set the
present value of all future cash flows equal to the cash
outflow at time 0

24. IRR rule an investment is acceptable if the IRR exceeds the re-
quired return. It should be rejected otherwise.

IRR>k: accept
IRR<k: reject

25. NPV profile a graphical representation of the relationship between an

investment's NPVs and various discount rates; IRR at
x-intercept

26. IRR and NPV 1. cash flows are conventional

rules will give the 2. projects are independent (not mutually exclusive)
same decision IF

27. IRR and non-con- when there are multiple sign changes in cash flows, there
ventional cash is no unambiguously correct answer
flows

28. multiple rates of the possibility of more than one discount rate making the
return problem NPV of an investment zero

29. mutually exclu- a situation in which taking one investment prevents the
sive investment taking of another; higher IRR might not have higher NPV
decisions

30. crossover rate

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the discount rate that makes the NPVs of two projects
equal

31. investing type get inflow, then outflow

cash flows for IRR, rule reversed

32. financing type outflow, then inflow -- more typical, use normal IRR rule
cash flows

33. advantages of 1. closely related to NPV, often leading to identical deci-

IRR sions
2. easy to understand and communicate

34. disadvantages of 1) may result in multiple answers with nonconventional

IRR cash flows

2) may lead to incorrect decisions in comparisons of mu-

tually exclusive investments

35. modified IRR modify cash flows, then calculate IRR; controversy around
(MIRR) this -- gets rid of multiple rates of return problem but
questionable if it's actually measuring anything all that
relevant or more useful than just calculating NPV

36. Discounting Ap- discount all negative cash flows back to present at re-
proach (MIRR) quired rate of return and then add them to initial cost; this
eliminates the multiple rates of return problem

37. Reinvestment compound all cash flows except the first out to the end of
Approach (MIRR) the project's life, then calculate IRR; "reinvest" cash flows
an don't take them out until very end

38. Combination Ap- blend of discount and reinvestment approaches: discount

proach (MIRR) negative cash flows back to present, and compound pos-
itive cash flows to end of project

39. Profitability In- present value of an investment's future cash flows divided
dex (PI) by initial cost
aka benefit-cost ratio
measures "bang for your buck"
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40. Profitability In- if PI>1, accept

dex Rule if PI<1, reject

41. Advantages of PI 1. Closely related to NPV, generally leading to identical

decisions
2. Easy to understand and communicate
3. May be useful when available investment funds are
limited

42. Disadvantages fo 1. may lead to incorrect decisions in comparisons of mu-

PI tually exclusive investments

43. cash flow identity cash flow from assets = cash flow to creditors + cash flow
to stockholders

44. cash flow from the total of cash flow to creditors and cash flow to stock-
assets holders, consisting of the following: operating cash flow,
capital spending, and change in net working capital

45. operating cash Cash flow that results from firm's day-to-day activities of
flow producing and selling.

Earnings before interest and tax + depreciation - taxes

Cash flows before tax + depreciation

46. capital spending the net spending on fixed assets (purchases of fixed as-
sets less sales of fixed assets)

47. change in net Net change in current assets relative to current liabilities
working capital for the period being examined.

48. cash flow to cred- interest paid less net new borrowing
itors

49. cash flow to dividends paid out by a firm less net new equity raised
stockholders

50.
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relevant cash a change in the firm's overall future cash flow that comes
flows for a pro- about as a direct consequence of the decision to take that
ject project

51. incremental cash the difference between a firm's future cash flows with a
flows project and those without the project

52. incremental cash consist of any and all changes in the firm's future cash
flows for project flows that are a direct consequence of taking the project
evaluation
any cash flow that exists regardless of whether or not a
project is undertaken (sunk cost) is not relevant

53. stand-alone prin- the assumption that evaluation of a project may be based
ciple on the project's incremental cash flows

54. sunk costs costs that have already been incurred and cannot be
recovered; irrelevant to decision whether to take on project

55. opportunity cost the most valuable alternative given up if a particular in-
vestment is undertaken; should be considered in project
decisions

56. side effects of can be positive or negative, but should be included in

incremental cash analysis when they are a direct result of project
flows

57. erosion negative impact on cash flows of existing product from the
introduction of the new product

58. projects usually closely resembles a loan as firm supplies working capital
involve an invest- at the beginning and recovers it at the end
ment in net work-
ing capital

59. financing costs financing costs, such as interest/dividends, are not rele-
and capital bud- vant in determining the future cash flows of a project
geting

60. must be aftertax

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measurement of
cash flows for
capital budgeting

61. pro forma finan- financial statements projecting future years' operations;
cial statements summarize much of the relevant info for a project -- in-
cludes sales, fixed costs, variable costs, depreciation,
EBIT, taxes, net income

62. project cash flow project operating cash flow - project change in net working
capital - project capital spending

63. project operating earnings before interest and taxes + depreciation - taxes
cash flow

64. salvage value the estimated value of a fixed asset at the end of its useful
life

65. Bottom-Up Ap- starts with accountant's bottom line (net income) and add
proach to Calcu- back depreciation
lating Operating
Cash Flows OCF = net income + depreciation

66. Top-Down Ap- start at top of income statement with sales and work down
proach to Calcu-
lating OCF OCF = sales -costs-taxes

67. Tax Shield Ap- OCF = (sales-costs) * (1-Tc) + (Depreciation*Tc)

proach to OCF where Tc = corporate tax rate

68. depreciation tax the tax saving that results from the depreciation deduction,
shield calculated as depreciation multiplied by the corporate tax
rate

69. depreciation per (purchase price - salvage value) / years of useful life
year

70. Initial Investment acquisition price +net working capital change - salvage
Calculation value after tax

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71. EBIT operating income - depreciation

72. Equivalent Annu- the present value of a project's costs calculated on an

al Cost (EAC) annual basis, aka EAA

73. Terminal Cash salvage proceeds from the asset + recovery of net working
Flow capital

74. How to solve 1. find NPV of each project over initial life
EAA problem 2. Determine the annuity cash flow that has a PV equal to
the project's NPV
3. Choose project with higher EAA

75. forecasting risk aka estimation risk; the possibility that errors in projected
cash flows will lead to incorrect decisions

76. sources of value should be able to point to a specific source of value such
and NPV as better product, efficiency in production, niche, etc.

positive NPV investments are rare in highly competitive

economic environment

77. scenario analy- the determination of what happens to NPV estimates

sis when we ask what-if questions

78. sensitivity analy- investigation of what happens to NPV when only one
sis variable is changed; useful in pinpointing areas where
forecasting risk is especially severe; if small changes in
projected value of some component of project cash flows
causes large changes in NPV (high sensitivity), then fore-
cast risk with that area is high; steeper slope = more
sensitive

79. simulation analy- a combination of scenario and sensitivity analysis

sis

80. drawbacks to don't tell you what to do if something bad happens

what-if analyses

81. capital rationing

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the situation that exists if a firm has positive NPV projects
but cannot find the necessary financing

82. soft rationing the situation that occurs when units in a business are allo-
cated a certain amount of financing for capital budgeting

83. response to soft should try to get larger allocation; should only be a
rationing one-time thing, if not there is a problem in the business
because they are passing up positive NPV projects which
fails the goal of maximizing shareholder wealth

84. hard rationing the situation that occurs when a business cannot raise
financing for a project under any circumstances; DCG
analysis breaks down because we don't have a fixed
required return, so best course of action is ambiguous -
probable that required return is so large that no positive
NPV project exists

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