# Capital Budgeting Decisions Flashcards

What is the tricky part when solving for the present value of a cash flow on a potential capital project?

You do not ever discount the cash flows with the same PVIF and you do discount these flows as an annuity. Just because the future cash flows are equal does not mean they discount to the PV at the same rate. Have to discount each cash flow according to the PVIF for each period it covers.

The discounted Payback Period gives you the clue on which period’s PVIF to use. (not annuity!)

Rule of Thumb - Do not discount with PVIFA ever!

Residual Income

Operating Income

(ROI based on minimum required ROR)*

= Residual Income

*represents imputed interest

Residual is the income after deducting imputed interest from operating income

Internal Rate of Return (IRR)

Focuses on profitability

Makes the NPV of all the cash flows $0

Reject projects whose returns are less than the IRR

Discounted Payback

Focuses only on LIQUIDITY

Considers TVM

Still disregards cash flows past payback period

PV of Annual Cash Flow / Initial Investment Outlays = # of periods

Length of time to recover investment

Payback

Focuses only on LIQUIDITY

No TMV considered

No profitability considered b/c ignores remainder of cash flows past payback period

Annual Cash Flow / Initial Investment Outlays = PB Period

Length of time to recover investment

Profitability Index

PV of Cash Flows AFTER initial Investment / Initial Outlays = Profitability Index

- Considers TVM and salvage value
- Best for scenarios where capital will need to be rationed among multiple projects b/c you want to identify projects with the highest profitability and invest capital. You don’t want to invest in something that is not going to be profitable. – IN PLAIN ENGLISH, THIS IS THE ONLY APPROACH THAT READILY COMPARES CAPITAL PROJECTS! Does not compute a rate of return, just the level of profitability.
- Requires extensive analyses and forecasts to be useful

Earnings Per Share (EPS)

NIAT / # of outstanding c/stk shares = EPS

*EBIT - I - T% = NIAT - debt financing offers interest as tax deduction

equity financing offers no tax deductions

Computing EBIT for debt financing vs. equity financing (stock issuance)

Debt financing = interest is tax deductible

EBIT - I - T% = NIAT (if only Debt)

Equity financing = No tax deductions, even for preferred dividends

EBIT - T% = NIAT (if only Equity)

What do preferred dividends, bonds, and fixed debt instruments have in common?

All have fixed payment streams. Treat preferred dividends like interest except it is not tax deductible.

Capital Turnover and what do you use it with?

Sales / Capital Employed = Capital T.O.

Use in XXXX

What do we need to be careful about discounting depreciation to the Present Value?

The tax implications. Depreciation is a tax benefit. Back in the income tax rate then discount it.

Ex - Bought a capital asset of $1.2M that is approved for MACRS depreciation. Never use salvage value for MACRS property. MACRS period is 4 years. Income tax rate is 40%. What’s the present value of MACRS depreciation in Year 4?

Ans:

Cost of the Asset x MACRS % for Year 4 x TAX % x PVIF for year 4 = the answer

Note we add back in tax because that is the savings back to the investor.

What do IRR and NPV have in common and what is the difference between them?

IRR and NPV are both discounting methods. They use the TVM.

IRR is different from NPV because IRR focuses on finding the DISCOUNT RATE while NPV already has the discount rate. IRR focuses on finding the discount rate that would get the NPV of future cash flows discounted to $0. We compare the IRR to the minimum required ROR on whether to accept or reject (accept only if IRR exceeds required ROR). NPV has nothing to do with finding the discount rate!

How do you find the cash flow based on the IRR?

Initial Investment = (Average Annual Cash Flow) x PVIFA

IRR (the discount rate, aka target rate)

Ex: $100,000 invested in asset for 5 years, 24% after-tax target rate, PV table provided. What’s the cash flow where the investor will be indifferent?

Solution - you know that the IRR is the rate that will discount the PV of average cash flows to $0.

PVIFA is n = 5, i at 24% => 2.7454

$100,000 = 2.7454x

X being the cash flow in question —> solve for X

x = $36,425 is the cash flow that the investor will be indifferent b/c NPV will be discounted to $0

Financial Leverage

% Change in Net Income

DFL = ——————————–

% Change in Net Operating Income

aka

EBIT -------------------- EBIT - Interest (amount of income available to commonSHE)

Represents the return available to companies when they finance their asset purchases with debt. The higher DFL, the better.

The higher the ratio (means EBIT increases or Interest is reduced), the more money the company has available AFTER financing asset purchases

Net Present Value method

*Computes the Rate of Return by discounting the average future cash flows to PV LESS Initial Investment.

NPV = Initial investment - PV of cash flows

Note the future cash flows are also netted (outflows - inflows) to arrive at net cash flows then discount to the present

Accept if NPV is $0 or higher. Never, ever accept a negative NPV because it means LOSS.