Capital Budgeting

• The net present value measures how much value is created or destroyed by undertaking a project.
• Projects with positive NPV are accepted.
• When choosing a combination of projects within a specified budget, choose the projects with the highest profitability index.
• One disadvantage of NPV is that it uses cash flow information which analysts must forecast, including long-term cash flows, which might be uncertain
• One disadvantage of NPV is that the appropriate discount rate needs to be estimated
• One disadvantage of NPV is that alternative rules might be easier to communicate to investors
• The Internal Rate of Return is the average return earned by undertaking an investment opportunity.
• Projects where IRR is greater than the opportunity cost of capital are accepted.
• The IRR is calculated by setting NPV to 0.
• If a project is financed, IRR should be accepted if it is less than r
• One disadvantage of IRR is that sometimes it does not exist
• One disadvantage of IRR is that when cash flows alternate in sign, there may be multiple IRRs
• The Payback Period is the time required for an investment to generate sufficient cash flows to recover its initial cost.
• Profitability Index = NPV / Original Investment Cost
• The Payback Rule states that you should only accept a project if the Payback Period is less than a benchmark.
• One advantage of the Payback Period Rule is that it adjusts for the uncertainty of later cash flows
• One disadvantage of the Payback Period Rule is that it ignores the time value of money
• One advantage of the Payback Period Rule is that it is biased towards liquidity
• One disadvantage of the Period Payback Rule is that it requires an arbitrary cut-off point and ignores cash flows beyond the cut-off date
• One disadvantage of the Payback Period Rule is that it is biased against long-term projects such as R&D and new projects
• Incremental Cash Flows are also referred to as Relevant Cash Flows
• Incremental Cash Flows involve additional operating cash flow a company receives from taking on a project and the opportunity costs incurred. Interest expenses are not included.
• The Stand-Alone Principle is the assumption that the evaluation of a project may be based on the project’s incremental cash flows.
• Erosion is the cash flow of a new project that comes at the expense of a firm’s existing projects.
• Incremental Earnings are project revenue from sales less project and depreciation costs.
• Reducing Balance Depreciation - a fixed percentage is applied to the book value to calculate depreciation
• A firm’s investment in net working capital resembles a loan as the cash initially invested into the project is recouped by selling inventories, collecting receivables, paying bills, etc.
• At the end of a project, investment in Net Working Capital is recovered
• Net Working Capital = Current assets - Current liabilities
• Net Working Capital = Cash + Inventory + Receivables - Payables
• Total Project Cash Flow is also referred to as Free Cash Flow
• EBIT = Sales - Costs - Depreciation
• Capital Expenditure = Salvage Value - Initial Investment
• After-Tax Salvage Value = Salvage Value + (Book Value - Salvage Value) * Tax Rate
• Free Cash Flow = EBIT * (1 - Tax Rate) + Depreciation - Capital Expenditure - Change in Net Cash Flow
• NPV = Present Value of Future Returns, adjusted for Tax with Depreciation + Present Value of Recouped Assets and Net Cash Flow - Initial Investment - Net Cash Flow