Capital Budgeting Flashcards
(20 cards)
Stages of Capital Budgeting
1. Identification of potential projects
2. Cost-benefit consideration
3. Implementation
4. Re-evaluation and Post-audit
both qualitative and quantitative information must be considered
Capital Investment Factors
3 Factors (CNN)
- Cost of Capital
- Net Investment
- Net Returns (Net Cash Flows or Net Income)
Net Investments
What to remember?
Outflows less Inflows
Remember → presently (at time 0)
NEW ASSET
Outflows
- acquisition cost, net of discount
- training cost, net of tax
- DACs
Yes
OLD ASSET
Outflows
- tax on gain in sale
- market value of idle assets
- removal cost, net of tax
Inflows
- tax on loss in sale
- proceeds from sale
- avoidable repairs, net of tax
- trade in value
Yes
WORKING CAPITAL
Outflows → increase
Inflows → decrease
NOTE: Cash Inflow (Terminal) = Add’l WC + Salvage Value
Yes
Net Returns
Net Income
- Direct = Inflows less Outflows
- Indirect = Net Income + Non Cash Expenses
How to solve for net cash flow (after tax)? What is the alternative way?
Cost Savings / Income
less : Incremental Depreciation
less : Income Tax
add back : Incremental Depreciation
ALTERNATIVE WAY
Cost Savings / Income * (1 - tax rate)
add : Incremental Depreciation * (tax rate)
Payback Period
- length of time required to recover net investment
Pros
- evaluates liquidity
Cons
- focus on return OF investment (X ROI)
- ignore cashflow after payback period
What is the formula? What is the rule?
Net Investment / Net Cashflow
Accept if ≤ half life
ARR
- evaluates profitability from accounting POV
Pros
- considers entire life
Cons
- uses accrual values rather than cashflows
- ignore inflation
What is the formula? What is the rule?
Average Annual NI / Net Investment
Accept if > COC
In a way, parang baliktad lang siya ng Payback Period
- however, instead of net cashflow → average annual NI
Bailout Payback Period
- almost same as payback period
- difference → for every year, guaranteed unang matanggap yung Salvage Value
Effect → mas mapapabilis marecover yung Net Investment
Payback Reciprocal
- provides a reasonable estimate of IRR
- non discounted technique used to estimate a discounted technique
What are the 2 conditions that need to be met?
- Payback period → acceptable
- Net cashflow → uniform throughout
Net Present Value
Pros
- COC → reinvestment rate
Cons
- incomparable if projects have different lives
What is the formula? What is the rule?
PV of Cash Inflow less PV of Cash Outflow
Accept if > 0
Add : Cash Inflow (terminal) → working capital and salvage value
Profitability Index
- used for ranking projects
What is the formula? What is the rule?
PV of Cash Inflow ÷ PV of Cash Outflow
Accept if > 1
IRR
- discount rate at which NPV = 0
Pros
- computes true return of project
Cons
- IRR → reinvestment rate
What is the formula? What is the rule?
PV of Cash Inflow = PV of Cash Outflow
Accept if > COC (same as ARR)
Palatandaan for the Discounted Formulas (NPV, PI, IRR)
NPV - net (minus)
PI - i is may tuldok (÷)
IRR - dalawang R (=)
This is known as break-even time. It is the time required to equalize discounted cashflows with the initial investment.
Discounted Payback
- nasa definition na halos
This is known as NPV point of indifference (where NPV of 2 projects are equal).
- Y-axis = NPV
- X-axis = discount %
Crossover Rate
This is known as annualized NPV. Used to compared projects with unequal lives. What is the formula?
Equivalent Annual Annuity
NPV ÷ PV Factor
TYPES OF PROJECTS
- Independent → for screening (use NPV)
- Mutually Exclusive → for preference (use PI)
Yes
2-Step Approach in Capital Rationing
- Rank according to Profitability Index
- Choose combination with highest NPV
since objective is to maximize NPV of firm
