Financial Decision Models: Part I_ M8

Question 1

What are the Capital Budget Models?

Answer 1

1.) Payback Model
2.) Discounted Cash Flows.

Question 2

What are the different types of Discounted Cash Flow Capital Budget Methods?

Answer 2

• NPV
• IRR
• Profitability Index

Question 3

What are relevant cost?

Answer 3

The total acquisition price of the asset is considered to be a relevant cost:

Acquisition cost of new machine is relevant cost: 180,000
Sale of old machine – cash received (30,000)
Tax on the gain of sale 30K-20K=10K x 30%: 3,000
Relevant cost: $153,000

Question 4

What should be considered when determining cash flows?

Answer 4

• Opportunity costs should be included in cash flow forecasts.
• Requirements for additional working capital are treated as cash outflows.
• Tax depreciation (not book) because it reduces the taxable income and cash payments for taxes.

Question 5

What is the hurdle rate/RRR/Discount Rate/Cost of Capital/WACC?

Required Rate of Return

Answer 5

RRR/Hurdle Rate/Discount Rate/Cost of Capital/WACC

• If the IRR (Internal Rate of Return) is less than the RRR/Hurdle Rate/Cost of Capital/WACC than Net Present Value (NPV) will be negative, and the project will be rejected.
• If the IRR is equal to or exceed RRR/hurdle rate/Cost of Capital/WACC than the project should be accepted and NPV will be positive.
• The RRR/Hurdle Rate/Cost of Capital/WACC must be less than the project’s IRR or the project will be rejected.
• The IRR is the rate earned by an investment that equates to a NPV of zero.

Question 6

What are the characteristics of NPV?

Net Present Value

Answer 6

• The net present value method recognizes the time value of money and discounts cash flows over the life of a project, using the minimum desired RRR/Hurdle Rate/Discount Rate/Cost of Capital (WACC).
• A project’s net present value is a function of current and future cash flows, including proceeds from the sale of the old asset (salvage value).

Increases NPV

• Extend the project life and associated cash inflows.
• Increase the estimated salvage value.
• Decrease the estimated effective income tax rate.

Decreases NPV

• Increase the hurdle rate/RRR/Discount Rate/Cost of Capital/WACC?

Question 7

How to calculate NPV?

Answer 7

After-Tax Cash Inflows X Present Value Interest Factor for each period, add all together than subtractract that from the Initial Investment (Outflow) this equals NPV
$(400,000) = 1.00 × (400,000)
139,200 = 0.87 × 160,000 (Year 1)
106,400 = 0.76 × 140,000 (Year 2)
66,000 = 0.66 × 100,000 (Year 3)
57,000 = 0.57 × 100,000 (Year 4)
50,000 = 0.50 × 100,000 (Year 5)
$18,600 NPV

Question 8

What are the rates used in the Net Present Value Analysis?

Answer 8

• Cost of capital (the cost of borrowing).
• Hurdle rate
• Discount rate
• Required rate of return

NOTE: The hurdle rate, the discount rate, and the required
rate of return are synonymous terms for an arbitrary rate set by management.

Question 9

How to analyze NPV?

Answer 9

• When the net present value (NPV) of a project is negative, that implies that the internal rate of return (IRR) is lower than the required rate of return (discount rate/RRR/Hurdle Rate).
• The NPV Method assumes that cash flows are reinvested at the discount rate/RRR/Hurdle rate used in the analysis.
• The NPV would be equal to zero if the Internal Rate of Return (IRR) was equal to the discount rate/required rate of return (RRR)/Hurdle rate.
• Select the project with the greatest NPV if the (IRR) is higher than (RRR) When RRR is greater than IRR and NPV is positive, and the project should be accepted.

Question 10

What is Discounted Payback?

Answer 10

• It measures years to payback.
• Measures risk (return of capital).
• A significant weakness is that it does not consider profitability.

Question 11

What are the characteristics of IRR?

Internal Rate of Return

Answer 11

• IRR is implied by NPV and compared to the discount %/RRR/Hurdle Rate assigned in the analysis.
• If IRR exceeds discount%/RRR/Hurdle Rate than project is accepted.
• If NPV breaks-even, that means that IRR is equal the discount %/RRR/Hurdle Rate assigned in the analysis and the project can be taken, however we love IRR to be greater than the discount %/RRR/Hurdle Rate assigned in the analysis instead.
• If NPV is negative that means the discount %/RRR/Hurdle Rate assigned in the analysis is less than IRR and the project is rejected.
• IRR measures percentage return.

Question 12

What techniques screen investments for compliance with capital investment policy?

Answer 12

• The internal rate of return (IRR).
• The return on investment method (ROI).
• The Net Present value method (NPV).

Question 13

What is capital rationing method?

Answer 13

• The profitability index is used for capital rationing.
• The profitability index is the ratio of the present value of net future cash inflows to the present value of the net initial investment.
• Ranking and selection of investments is made by listing projects in descending order.
• Limited capital resources are applied in the order of the index until resources are either exhausted or the investment required by the next project exceeds remaining resources.

Question 14

What is profitability index?

Answer 14

• PV of future CF/PV of initial investment.
• Is a variation of the net present value capital budgeting model.
• RULE: it is the ratio of the present value of net future cash inflows to the present value of the net initial investment.
• It is also referred to as the “excess present value index” or simply the “present value index.”
• Companies hope that this ratio will be over 1.0, which means that the present value of the inflows is greater than the present value of the outflows.
• The profitability ratio requires detailed long-term forecasts of project’s cash flows.
• For longer term projects, cash flow projections might be either unavailable or unreliable.
• The time value of money is considered in both the numerator
  and the denominator of the profitability index.
• Incorporates discounted cash flows based on hurdle rates that can be fully integrated with weighted average cost of capital or marginal cost of capital thresholds.
• Use of these concepts is fully compatible with maximization of shareholder value.

Question 15

What are the decision included in the capital budget?

Answer 15

• Financing large expenditures.
• Financing short-term working capital needs.
• Selecting among long-term investment alternatives.
• Involves the management’s evaluation of an uncertain future.
• It involves long-term commitments for asset acquisition.
• Involves long-term financing decisions.
• Involves Management’s decisions on the increased requirement for capital investment
• Involves Managements required return.
• Involves Managements cost of capital require evaluation of an uncertain future.

Question 16

What are the methods used to analyze capital budget decisions?

Answer 16

• Different rates may be used under thenet present value method to reflect different risk and reinvestment opportunities over the life of the project. As long as the net present value is greater than zero, the decision is acceptable.
• The net present value method uses the hurdle rate as the discount rate.
• If the net present value of a project is positive, it has exceeded the hurdle rate.
• The internal rate of return (IRR) calculates a specific rate of return for the project. If the internal rate of return (IRR) is greater than the hurdle rate, the project is acceptable.
• The internal rate of return (IRR) method is not able to track reinvestment results.
• Cash flows under the internal rate of return method are assumed to be reinvested at the same rate of return as the original investment.
• That is often an unreasonable assumption and could lead to incorrect conclusions.
• No method of capital budgeting eliminates risk since the results are only expected amounts based on assumptions of the future.

Question 17

How does a company decide to accept the investment after NPV is Positive or IRR exceeds the hurtle rate is already confirmed?

Answer 17

• A company with unlimited resources for capital investments should accept all positive NPV investment options.
• Any company with limited resources for capital investment must ration scarce capital investment funding.
• Excess cash does not mean the company has unlimited funds for capital investment.

Question 18

What does annual depreciation expense do to a company’s cash flows?

Answer 18

• Depreciation provides a tax shield, which means it reduces taxable income (a cash outflow).
• If depreciation is $15,000, the annual tax savings (and increase in after-tax cash flows) is $15,000 × 30% = $4,500.
• Net income will be lower by $10,500 [$15,000 × (1 − .30)] as a result of
  depreciation.
• Depreciation, like any expense on the income statement, will lower net income.

NOTE: (70% is the non-taxed portion the tax rate portion of 30% is subtracted from net income because it is taxable).

• Net income will be lower by the amount of depreciation less the tax benefit provided.
• Depreciation is a noncash expense but affects cash flow indirectly because it is a tax-deductible expense item.
• CF Tax decrease rate = (Annual Depreciation x TR)
• After-Tax Cash Flow = [CF x (1-TR)] + [(Annual Depr. x TR)]

Question 19

What is the difference in MACRS and Straight-line when calculating tax shield?

Answer 19

• MACRS and straight-line depreciation will be equal in total (only the timing differs).
• The discounting will result in different present values based on the differing timing.

Question 20

What is the difference between annuity due (inflows received at the beg of yr.) and annuity of $1 received at the end?

Answer 20

• Since cash inflows are received at the end of the year, the analysis uses the present value of an ordinary annuity of $1 per period for six periods.
• The annuity due factor would be used if the cash inflows were received at the beginning of each year.