Capital budgeting

Question 1

Net Present Value for Budgeting focuses on

Answer 1

Cash Flow

Question 2

Payback method does what

Answer 2

Ignores total project PROFITABILITY. Simply looks at the time it takes to recover the INITIAL investment.

Subsequent cash flows are ignored.

Main advantage of this method - IT’S SIMPLISTIC

Question 3

Internal Rate of Return (IRR)

To calculate the IRR:

Sometimes use the term “equates” to mean “equals”

Answer 3

The IRR determines the discount rate that will equate the discount cash inflows with the outflows, thus resulting in no gain or loss (Breakeven).Does not give $$ amt. just %.

Net incremental investment (inv. required)
__________________________________ =IRR
Net annual cash flow

Question 4

The Profitability Index (aka - Excess Present Value Index or simply the Present Value Index)

Answer 4

Present Value of the Net Future Cash Inflows
___________________________________ = Prof Index
Present Value of the Net Initial Investment

A ratio over 1 is Good - this means that the present value of the inflows is greater than the present value of the outflows.

Question 5

Discounted Cash Flow (DCF)

Two Techniques that Use the Time Value of Money
to measure the present value of cash inflows and outflows expected from a project.

Answer 5

NPV (“Yeah You Know Me”) - Net Present Value

and

IRR (“Let’s Have a Drink at The Bar”) -Internal Rate of Return

Question 6

Capital Rationing

Answer 6

Capital is limited and must be rationed.

Mgmt. will allocate capital to combination of projects with the maximum net present value.

Ranking is best accomplished by using Profitability Index.

Question 7

Profitability Index (used for capital rationing decisions)

Answer 7

Present Value of Net Future Cash Inflow
_______________________________ = Prof. Index
Present Value of net Initial Investment

PI > 1 Then you have positive NPV(numerator>denominator)

Question 8

Net Present Value Calculation

Note: the method of funding a project has NO EFFECT
on the NPV model.

Answer 8

1. After-tax cash flow = Annual net cash flow x (1 - tax rate)
2. PLUS deprec. BENEFIT = deprec x tax rate
   (also include any final year cash flow)
3. Multiply result by present value of an annuity
4. Subtract initial cash outflow
5. Net Present Value

Question 9

If you have unlimited capital

Answer 9

All investments with a positive NPV should be pursued.

Question 10

NPV & inflations

Answer 10

If you are figuring NPV and Inflation is expected,

you need to Increase the Discount Rate due to the additional risk, and Increase the Expected Cash inflow for inflation.

Question 11

Stages of Cash Flow:

Step 1: Net Initial Outflow

Step 2: Future Operating Cash Inflows (buy the eq. to generate cash inflow)

Step 3: The Disposal of the Project

Answer 11

Step 1 : Net Initial Cost
Invoice + Shipping + Installation (outflows)
Increase in necessary working capital (outflow)
LESS: PROCEEDS FROM THE SALE OF THE OLD EQ.
= Net Initial outflow

Step 2: Future Operating Cash Inflows
Future annual operating cash inflow but reduce it for tax
After tax cash flow = Pretax cash flow x (1 - tax rate)

         PLUS (NOT MINUS!!!)

   Depreciation Amt. x Tax Rate

Step 3:  One time terminal yr. net cash INFLOW
        Selling price = Inflow
       \+Decrease in WC = Inflow
       - Gain x Tx% = Outflow
       \+ Loss x Tx% = Inflow

Final yr. has 2 inflows, operating cash flow + terminal yr. cash flow disposal.