Flashcards in BEC 3 Financial modeling projections and analysis Deck (45):

1

## Relevant data concept

### revenues and costs related to financial decisions are only deemed to be relevant if they change as a result of selecting different alternative.

2

## Cost behavior

### Fixed or variable costs may be relevant (more variable though)

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## Characteristics of relevant costs

### Often share similar characteristics like their specific traceability to cost objects that may change as a result of selecting different alternatives.

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## Direct costs

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- Relevant

- can identified with or traced to a given cost object

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## Prime costs

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- Relevant

- Direct material or direct labor

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## Discretionary costs

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- Relevant

- Costs arising from periodic budgeting decisions by management to spend in areas not directly related to manufacturing.

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## Opportunity cost

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- Relevant

- cost of foregoing the next best alternative when making a financial decision.

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## Relevant costs

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1. Direct

2. Prime

3. Discretionary

4. Opportunity

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## Alternative terms for relevant costs and revenues

###
1. Incremental costs

2. Avoidable costs and revenues

a. unavoidable costs

b. sunk costs

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## Incremental costs

### differential costs or out of pocket costs are the additional costs incurred to produce an additional amount of the unit over the present output.

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## Avoidable costs and revenues

###
result from choosing one course of action instead of another. As a result the firm avoids the cost or revenue associated with the other course of action:

a. Unavoidable costs - costs are the same not matter what you do

b. Sunk costs - unavoidable costs, because they were already spent and cant be recovered.

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## Cash flow effects

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1. Direct effect - the company pays and receives cash that is directly related to the capital investment. Immediate effect on the amount of cash available

2. Indirect effect - transactions either indirectly associated with a capital project or that represent non cash activity that produces cash benefits or obligations are termed indirect cash flow effects.

3. Net effect - the total of the direct and indirect effects of cash flows from a capital investment

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## Stages of cash flow

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1. Inception of the project

a. Working capital requirements

(1) Additional working capital requirements

(2) Reduced working capital requirements

b. Disposal of the replaced asset

(1) asset abandonment

(2) asset sale

2. Operations

3. Disposal of the project

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## Stages of Cash flow

###
Step 1 Initial outflow

Invoice + Shipping + Installation (Outflow)

+ Increase in Working Capital (Outflow)

- Cash proceeds on sale of old equipment (Inflow)

= Net initial outflow

Step 2 Operations

Future annual cash inflow operations

Pretax cash inflow x (1-Tax rate)

+ Depreciation x Tax rate

Step 3 Disposal

"One time" terminal year inflow (Disposal)

Net proceeds from the sale of the asset (Net inflow)

- Severance pay (Outflow)

+ Tax savings (Inflow)

+ Decrease in Working capital (Inflow)

= Terminal year net inflow

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## Asset sale

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Net proceeds on sale of old asset (net of tax):

Proceeds on sale (Inflow)

- Tax paid on gain (Outflow)

+ Tax saved on loss (Inflow)

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## Calculation of aftertax cash flows

###
After-Tax cash flows - relevant to capital budgeting

(1) Estimate net cash inflows (cash inflows - cash outflows)

(2) Subtract noncash tax deductible expenses to arrive at taxable income

(3) Compute income taxes related to a project's income or loss for each year of the project's useful life

(4) Subtract tax exp from net cash inflows to arrive at after tax cash flows

(5) Multiply net cash inflows by (1-Tax rate) and add the tax shield associated with noncash exp. The sum of these two amounts will equal the after tax cash flows.

(6) The tax savings or exp related to a particular cash flow equals the amount of the expense or income times the firm's marginal income tax rate.

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## Discounted Cash flow

### Discounted cash flow methods are techniques that use time value of money concepts to measure the present value of cash inflows and cash outflows expected from a project.

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## Objectives and components of discounted cash flow as used in capital budgeting

###
a) relevant cash flows discounted to present value

b) evaluated by:

- the dollar amount of the initial investment,

- the dollar amount of future cash inflows outflows,

- the rate of return desired for the project

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## Rate of return desired for the project

###
The rate used to discount future cash flows is set by management using several different approaches:

a) management may use a weighted average cost of capital method

b) management may simply assign a target for new projects to meet

c) management may recommended that the discount rate be related to the risk specific to the proposed project

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## Limitation of discounted cash flow-Simple constant growth assumption

###
- Discounted cash flow methods are widely viewed as superior to methods that do not consider the time value of money,

- use a simple constant growth single interest rate assumption, which is often unrealistic, because over time, as management evaluates its alternatives, actual interest rates or risks may fluctuate

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## Discounted cash flow is the basis for net present value methods

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1. Calculate after tax cash flow = Annual net cash flow x (1-Tax rate)

2. Add depreciation benefit = Depreciation x tax rate

3. Multiply result by appropriate present value of an annuity

4. Subtract initial cash outflow

5. Net present value

22

## Net present value method

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- focuses decision makers on the initial investment amount that is required to purchase in a capital asset that will yield returns in an amount in excess of a management designated hurdle rate

- requires managers to evaluate the dollar amount of return rather than either % of return or years to recover principal as a basis for screening investments

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## Calculation of net present value

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1. Estimate the cash flows

a. Ignore depreciation

b. Ignore method of funding

2. Discount the cash flows

3. Compare

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## Interpreting the NPV method

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1. Positive result = make investment

2. Negative result = do not make investment

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## Interest rates adjustments for required return

### Net present value analysis may incorporate many types of hurdle rates, such as the cost of capital, the discount rate of the opportunity cost, rates are determined by management

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## Adjustments to rate

###
a. Risk - discount rates may be increased to further factor differences in risk into the analysis

b. Inflation - rates may be raised to compensate for expected inflation

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## Differing rates

### may be used for different time periods using the NPV method.

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## Discount rate applied to qualitatively desirable or non-optional investments

### A project that meets qualitative management criteria for investment is purely subject to financing, rather than capital budgeting. The discount rate used for NPV evaluation should be the after-tax cost of borrowing (incremental borrowing rate)

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## Advantage and limitations of the Net Present Value Method

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1. Advantages - flexible and can be used when there is no constant rate of return required for each year of the project

2. Limitations - does not provide the true rate of return on the investment

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## Capital rationing

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1. Unlimited capital - all investments with a positive NPV should be pursued.

2. Limited capital:

a. Importance

b. Ranking and acceptance

31

## Profitability index

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- the ratio of the PV of net future cash inflows to the PV of the net initial investments

- "excess present value index"

- "present value index"

- ranking and selection of investment alternatives anticipate positive net present values for all successfully screened investments

- profitability ratio should be over 1.0

Profitability index = PV of net future cash inflow / PV of net initial investment

32

## Measures cash flow return per dollar invested

###
1. Measures cash flow return per dollar invested - the higher the better

2. Application - projects with positive NPV are ranked in descending order by their profitability index

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## Internal rate of return

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- the expected rate of return of a project and is sometimes called the time-adjusted rate of return

- determines the PV factor that yields an NPV equal to zero,

- focuses the decision maker on the discount rate at which the PV of the cash inflows = PV of the cash outflows

- focus is on %%%%

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## Interpreting IRR for Investment decisions

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1. Accept when IRR > Hurdle Rate

2. Reject when IRR < Hurdle rate

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## Limitations of IRR

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1. Unreasonable reinvestment assumption - If internal rates of return are unrealistically high or unrealistically low, assumed returns on reinvested cash flows based on IRR rates could lead to inappropriate conclusions.

2. Inflexible cash flow assumptions - the timing of the amount of cash flows used to determine IRR can be misleading when compared to the NPV method. The IRR method is less reliable than the NPV method when there are several alternating periods of net cash inflows and net cash outflows or the amounts of the cash flows differ significantly.

3. Evaluates Alternatives Based Entirely on Interest rates

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## Payback period method

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- time required for the net after tax cash inflows to recover the initial investment in a project

- liquidity - project's liquidity and the time during which return of principal is at risk

- risk - the greater the risk of the investment, the shorter the payback that is expected by the company

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## The formula for calculating the payback period

### Payback period = Net initial investment / Increase in annual net after tax cash flow

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##
Cash flow assumptions

Uniform cash inflows

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The net cash inflows are assumed to be constant for each period during the life of the project. The payback period is computed at the point of initial investment using after tax cash flows.

a. Project evaluation - the net cash inflow would be the net cash receipts associated with the project

b. Asset evaluation - the net annual cash inflow will be the savings generated by use of the new equipment

c. Depreciation tax shield -add it (depreciation exp is not considered, unless it is a tax shield)

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##
Cash flow assumptions

Non-uniform cash flows

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The standard payback formula shown above applies to uniform annual cash inflows. If cash flows are not uniform, a cumulative approach to determining the payback period is used.

a. Accumulate until equal to initial net investment - the net after tax cash inflow per year is used as the basis for evaluation of projects with nonuniform cash flows. These net after tax cash inflows are accumulated until the time that they equal the initial investment.

b. End of the payback period - the point at which the cumulative net after tax inflows equal the initial net investment is the end of the payback period.

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## Advantages of payback

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1. Easy to use and understand

2. Emphasis on liquidity

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## Limitations of payback

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1. the time value of money is ignored

2. project cash flows occurring after the initial investment is recovered are not considered

3. reinvestment of cash flows is not considered

4. total project profitability is neglected

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## Discounted payback method

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- computes the payback period using expected cash flows that are discounted by the project's cost of capital

- evaluates how quickly new ideas are converted into profitable ideas

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## Discounted payback method

### - computes the payback period using expected cash flows that are discounted by the project's cost of capital

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## Objective of discounted payback method

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1. Focus on liquidity and profit

2. Evaluation term

3. Common project using discounted payback

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