CHAPTER 8 Flashcards
• Cost of Capital – 3 types of budgets
- Strategic plan (budget for CFO), - Organization decides on major programs and the resources to devote to them- pg. 271
- Capital budget (what assets you invest in to implement your strategy; {capital budgets}), - What long term (capital) investments to undertake and how to finance them
- Operating budgets (day to day plan)
Definition of Cost of Capital aka Discount rate
the interest rate that analysts use in computing the PV of future cash flows
Can also get rate based off of loans, stock, and management requirements
Cost of Capital- Appropriate Rate
The appropriate rate has 3 elements
• A pure rate of interest (between 0-5%) reflecting the productive capability of capital assets
• A risk factor reflecting the riskiness of the project (risk premium)
o The greater the project’s risk the greater the discount rate
• An increase reflecting inflation expected to occur over the life of the project
o The higher the expected inflation the higher the discount rate
Cost of Capital- Other Terms
Risk-free rate includes the pure interest rate increased to reflect expected inflation.
o The real interest rate includes the pure interest rate and a premium for the risk of the investment, but no increase for expected inflation.
o The nominal interest rate includes all three factors- pure interest, risk premium, and expected inflation
Methods of evaluating capital investments- NPV
- Change in Cash Inflows (pV)- Change in Cash outflows (pV)= Change in Cashflow (NPV)
- Accept if NPV is ≥ 0 and the return rate is greater than the discount rate
Methods of evaluating capital investments- Initial Cash Flow
Happen at the beginning of the project and include:
• Asset cost (outflow)
• Freight and installation cost (outflow)
• Cash proceeds from disposing of existing assets made redundant or unnecessary by the new project (inflow)
• Income tax effect of gain (loss) on disposal of existing assets- outflow (inflow)
Methods of evaluating capital investments- Periodic Cash Flow
Occurs during the life of the project and includes:
• Receipts from sales (cash, not revenues) – inflow
• Opportunity costs of undertaking this project (lost other inflows)-outflow
• Expenditures for fixed and variable production costs- outflow
• Savings for fixed and variable production cots – inflow
• Selling, general, and administrative expend. – outflow
• Income tax effects of flows form above – opposite in sign to the cash flow that generates the tax consequences
• Savings in taxes caused by deductibility of deprecation on tax return (depreciation tax shield)-inflow
• Loss in tax savings from lost depreciation (loss of tax shield)-outflow
• Do not include noncash items such as financial acct depreciation expense
Methods of evaluating capital investments- Terminal Cash Flow
Occurs at the end of a project and includes: • Proceeds on salvage of equipment-inflow
• Tax gain on disposal- inflow
• Tax loss on disposal-outflow
IRR (time adjusted rate of return )
rate when used as a discount rate, which causes NPV to be 0. IRR discounts the future cash flows to a PV to 0 which is equal to the initial investment.
Cuttoff or hurdle rate
required rate of return in a DCF.
• Accept project if IRR exceeds cutoff rate
Payback period
time it takes to recover your initial investment
Investment divide by annual cash flow
Payback period rules
See notes
Depreciation
affects cash flow because the firm can deduct it from otherwise taxable income, reducing taxes payable
Tax Effects - On working Capital
Investment of working capital - Only time to recognize working capital occurs when the firms needs to let cash sit idle as a condition of undertaking an investment
Behavioral Aspects of Capital Budgeting
o Problems:
• Biased estimates
• Desire to implement a project, meet perf.
Eval. Measures,
o How to fix: policies, procedures, and performance measure top encourage and reward accurate estimates and management needs to consider the planners motivation
