finance exam 4

operating expenses

Short-term expenses are where the benefits are enjoyed in the same period as the expense—such as the diesel fuel to run the vehicle on a daily basis.

capital expenses

Long-term expenses involve obtaining the major asset: a company will pay a substantial amount today to obtain the vehicle, but will use it in its business over several years.

Capital Budgeting Process

a formal way for managers to guide their capital expenditure decisions.

Develop Long Term Goals

First step of Capital Budgeting Process

Screen Investments

Second step of Capital Budgeting Process

Evaluate Alternatives

Third step of Capital Budgeting Process

Implement the Project

Fourth step of Capital Budgeting Process

Control

Fifth step of Capital Budgeting Process

Audit

Sixth step of Capital Budgeting Process

Net Present Value (NPV)

A dollar measure of the impact of a project on the company's wealth. It uses the opportunity cost to bring all of the project's incremental cash flows back to the present and then compares inflows to outflows to see if the project is acceptable.

Internal Rate of Return (IRR)

The rate of return earned on a project. To make a decision managers must compare this to the opportunity cost. They should only accept the project if it earns more than should be expected given other projects of equivalent risk.

Profitability Index (PI)

A ratio that calculates the relative wealth created per dollar invested. It uses the same inputs--present values of inflows and present value of outflows--used for NPV but shows managers the relative wealth created rather than the total wealth created. This specialized, relative measure has some specialized applications.

Payback

the amount of time it takes for a project to earn its initial investment back. The shorter the period the quicker the company gets its initial investment back and begins to see a profit. Managers set the maximum period they will accept. Projects with periods shorter than this maximum will be acceptable; projects exceeding this project will be rejected.

average accounting return

the rate of return earned on a project. It is calculated by comparing the average net income earned by a project to the cost of the project, measured by the average book value. In a way similar to Payback, managers will set a minimum AAR. If the project earns more than this specified rate, it is accepted. If the ARR is less, the project will be rejected. While useful for some purposes the AAR is not based on future cash flows, and does not use the opportunity cost. It is thus of limited use in making decisions about the future.

Economically independent projects

where making one choice is independent of other choices. Managers can accept all projects that are wealth-increasing.

Mutually exclusive projects

projects where choosing one project precludes the adoption of other projects. Managers must rank these projects by some criteria and select the best project.

Capital rationing

The case where funds are limited to a fixed dollar amount and must be allocated among competing projects. Managers need a method of ranking projects, or portfolio of projects, by their desirability and selecting the higher-ranked projects until their funds are fully committed.

Soft rationing

Limits on investments are made by managers for better control of the firm.

Hard rationing

Funds are not available and managers must choose the best set of projects given their capital constraints.

cost of capital

The opportunity cost for a capital budgeting project. The minimum rate of return that investors require for a company to take on a project.

Incremental Cash Flows After Taxes (ICFAT)

the periodic cash outflows and inflows that occur if, and only if, an investment project is accepted. Incremental cash flow focuses on the project, not the company as a whole.

Economic interdependencies

Adopting a project would change the cash flows in other parts of the company.

Synergy

The positive effect where adopting the project would increase the cash flows from existing operations.

Erosion

The negative effect where adopting the project would decrease the cash flows from existing operations.

Sunk costs

Costs that have already been incurred. As such they would not be affected by the capital budgeting decision and are thus not incremental cash flows.

Revenue enhancing project

These projects introduce a new product, improve an existing product, or involve other aspects to increase sales, such as a major marketing campaign.

Cost reduction project

These projects focus on reducing costs. Outsourcing of business functions or production, improving supply chains, employing machine learning lead to lower costs and thus higher income.

Corporate Social Responsibility project

While the corporation's function in society is to efficiently produce goods and services, corporations are expected to be good citizens. These projects do help society, and also enhance the reputation of the company.

Regulatory requirements project

Governments regulate economic activity to protect society from harmful effects. The most cost-effective way to handle toxic waste from a production process is to dump it into Lake Lady Bird. These projects are undertaken because they are required.

Free cash flow/Cash flow from assets

The amount of cash generated by a company that is available to distribute to the firm's creditors and owners.

Operating cash flow

earnings before interest plus depreciation minus taxes. And, it's important to remember that these cash flows have not yet occurred--we estimate what they would be if the project were to be adopted.

Capital spending

is the cash that must be invested in the project's capital assets to produce the projected operating cash flow! Any operating cash flow that must be invested in productive assets is not available for the company's security holders, so the projected capital expenditures must be subtracted from the operating cash flow.

Additions to Net Working Capital

investments in the project's short-term assets. A project may require investments in such items as accounts payable and inventory. Some operating cash flow may have to be invested in these short-term assets and is thus not available (free) to be paid to the security holders.

Initial cash flows

Expenditures that are undertaken to obtain assets and begin a capital budgeting project.

Direct expenditures

expenditures directly connected with obtaining the capital asset.

Indirect expenditures

expenditures resulting from our decision to purchase the asset, should also be included at the project's inception.

Operating cash flows

Cash flows received from the operating of the capital budgeting project.

Terminal cash flows

Cash flows incurred in closing down a capital budgeting project.

Weighted Average Cost of Capital (WACC)

The weighted average cost of a firm’s common equity, preferred stock, and debt. Used as the discount rate for capital budgeting decisions.