Chapter 10 Notes Flashcards
(22 cards)
Capital budgeting is
the process of evaluating and selecting long-term investments that are consistent with the firm’s goal of maximizing owner wealth.
A capital expenditure is
an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year.
An operating expenditure is
an outlay of funds by the firm resulting in benefits received within 1 year.
The 5 Step Capital Budget Process
1: Proposal Generation.
2: Review and Analysis
3: Decision Making
4: Implementation.
5: Follow-up
Independent vs Mutually exclusive projects.
Independent projects are projects whose cash flows are unrelated to (or independent of) one another; the acceptance of one does not eliminate the others from further consideration
Mutually exclusive projects are projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.
Unlimited Funds vs Capital Rationing
Unlimited funds is the financial situation in which a firm is able to accept all independent projects that provide an acceptable return.
Capital rationing is the financial situation in which a firm has only a fixed number of dollars available for capital expenditures, and numerous projects compete for these dollars.
Accept-Reject versus Ranking Approaches:
An accept–reject approach is the evaluation of capital expenditure proposals to determine whether they meet the firm’s minimum acceptance criterion.
A ranking approach is the ranking of capital expenditure projects on the basis of some predetermined measure, such as the rate of return.
payback method
the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows.
The length of the maximum acceptable payback period is determined by management
If the payback period is less than the maximum acceptable payback period, accept the project.
If the payback period is greater than the maximum acceptable payback period, reject the project.
Payback Period: Pros
The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects.
Its popularity results from its computational simplicity and intuitive appeal.
By measuring how quickly the firm recovers its initial investment, the payback period also gives implicit consideration to the timing of cash flows.
Because it can be viewed as a measure of risk exposure, many firms use the payback period as a decision criterion or as a supplement to other decision techniques.
Payback Period: Cons
The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number.
A second weakness is that this approach fails to take fully into account the time value of money.
A third weakness of payback is its failure to recognize cash flows that occur after the payback period.
Net present value (NPV)
Present value of cash inflows – Initial investment
Decision criteria for NPV
If the NPV is greater than $0, accept the project.
If the NPV is less than $0, reject the project.
If the NPV is greater than 0,
The firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV.
How do we find the profitability index?
Take the total cash flows divided by the initial investment.
How to decide based on IRR?
If the IRR is greater than the cost of capital, accept the project.
If the IRR is less than the cost of capital, reject the project.
IRR vs NPV
There is no guarantee that NPV and IRR will rank different projects in the same order. However, both methods should reach the same conclusion about the acceptability or non-acceptability of the same project
Net present value profiles are:
graphs that depict a project’s NPVs for various discount rates.
Comparing NPV and IRR Techniques: Conflicting Rankings
Conflicting rankings are conflicts in the ranking given a project by NPV and IRR, resulting from differences in the magnitude and timing of cash flows.
One underlying cause of conflicting rankings is the implicit assumption concerning the reinvestment of intermediate cash inflows—cash inflows received prior to the termination of the project.
NPV assumes intermediate cash flows are reinvested at the cost of capital, while IRR assumes that they are reinvested at the IRR.
Comparing NPV and IRR Techniques: Timing of the Cash Flow
When much of a project’s cash flows arrive early in its life, the project’s NPV will not be particularly sensitive to the discount rate.
On the other hand, the NPV of projects with cash flows that arrive later will fluctuate more as the discount rate changes.
The differences in the timing of cash flows between the two projects does not affect the ranking provided by the IRR method.
Comparing NPV and IRR Techniques: Magnitude of the Initial Investment
In these cases, the IRR and NPV methods may rank projects differently.
The IRR approach (and the PI method) may favor small projects with high returns (like the $2 loan that turns into $3).
The NPV approach favors the investment that makes the investor the most money (like the $1,000 investment that yields $1,100 in one day).
Comparing NPV and IRR Techniques: Which Approach is Better?
On a purely theoretical basis, NPV is the better approach because:
NPV measures how much wealth a project creates (or destroys if the NPV is negative) for shareholders.
Certain mathematical properties may cause a project to have multiple IRRs—more than one IRR resulting from a capital budgeting project with a nonconventional cash flow pattern; the maximum number of IRRs for a project is equal to the number of sign changes in its cash flows.
Despite its theoretical superiority, however, financial managers prefer to use the IRR approach just as often as the NPV method because of the preference for rates of return.
