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Capital Budgeting
Decision to invest in tangible or intangible assets. Long term decisions for the firm. Can be investment or financing decisions.
Pay back period
Time until cash flow recovers from the initial investment of a project. Ideal for small, short term decision making. Future value of cash flows.
Discounted payback period
Time until present value of cash flows recover the initial investment of a project. Each cash flow from the project is discounted to present value. Incorporates TVM principals but still does not consider any projects after the payback period
How to calculate Net Present Value
The present value of a projects cash flows minus investment.
Mutually exclusive projects
Two or more projects that cannot be pursued simultaneously
When dealing with mutually exclusive projects, pick the project that…
Has the highest Net Present Value (NPV)
Net Present Value Model
Usually considered to be the best of the capital decision making models
Profitability index
A measurement of a project or investments attractiveness. A useful tool for ranking projects.
Calculating Profitability index
Ratio of a projects Net Present Value (NPV) to the initial investment. Present value of benefits divided by initial investment cost.
Internal Rate of Return (IRR)
The rate of return Implied by its cost and future cash flows. Is the discount rate that sets NPV equal to zero
Internal Rate of Return (IRR) Rule
If IRR > opportunity cost of capital, accept the project; if IRR < opportunity cost of capital, reject the project.
Pitfalls of IRR Case 1
Mutually exclusive projects: With NPV, choosing project with highest NPV is often the best choice ◦ With IRR, choosing the highest IRR can lead to poor decision making ◦ This is due to either the timing of cash flows (projects have different lives) or large differences in outlays
Pitfalls of IRR Case 2
Lending or Borrowing: Rule for IRR: NPV must be falling ◦ Not the case when lending and borrowing (positive initial CF, negative future CFs)
Pitfalls of IRR Case 3
Multiple IRR’s: Occurs with non-normal CFs (change in sign of CF during stream)
Equivalent Annual Annuity
The cash flow per period with the same present value as the cost of buying and operating a machine
Discounted Cash Flow (DCF)
A broad, inclusive term largely for preparation of cash flow estimates of a project, use of those estimates in capital budgeting analysis, DCF is a part of the NPV calculation
Incremental cash flow
Cash flow that a company acquires when it takes on a new project
Erosion costs
Costs that arise when a new product or service competes with revenue generated by a current product or service
Synergy gains
Increased revenues for other existing products related to the introduction of a new product
Investment versus financing
Typically, how a project will be financed is ignored when valuing it as an investment. Is the projects existence dependent on financing?
Opportunity cost
The benefit or cashflow that is forgone as a result of an action. Should be included as an incremental cash flow
Terminal cash flows
The cash flow resulting from termination and liquidation of a project at the end of its economic life
Capital expenditure
Generally involved an initial cash outflow, but attention should also e paid to the disposal of the capital equipment
Operating cash flows (OCF)
What is generally cared about when forecasting incremental cash flows. A measure of the amount of cash generated by a companies normal business operations.
Operating cash flows formula
OFC = revenues - expenses - taxes
Straight-line depreciation
Fixed depreciation expense over the life of an asset. Typically equals cost divided by usable life.
Double-declining depreciation / MACRS
Depreciation expense declines over life of an asset. Typically straight-line expense x 2 per year.
“Bonus” depreciation
Allows for 100% depreciation expense
Cash flows versus accounting profit
Cash flows shows how much money moves in and out of your business, while profit illustrates how much money is left over after you’ve paid all your expenses.
Changes in working capital
Shows the net affect on cash flows of this adding and subtracting from current assets and current liabilities. When changes are negative, the company is investing heavily in its current assets, or else drastically reducing its current liabilities.
Risk
A measure of the uncertainty in a set of potential outcomes for an event. How those outcomes differ from expected. Potential for loss but also uncertain gain.
Variance
The probability-weighted average of squared deviations from expected value (mean) and outcome. A measure of volatility.
Diversication
A strategy designed to reduce risk by spreading the portfolio across many investments. By dividing up investments across many relatively low-correlated assets, its possible to reduce ones exposure to risk.
Idiosyncratic risk
The risk inherent in an asset or asset ground due to specific qualities of that asset. Also known as specific risk
Systematic or non-diversifiable risk
Economy-wide sources of risk that affect the overall stock market. The uncertainty inherent in a company or industry investment.
Well-diversified portfolio
One whose specific risk has been eliminated
Beta
Measures the expected increase or decrease of an individual stock price in proportion to movements of the stock market as a whole. A measure of risk for a well-diversified portfolio
Interpreting Beta
A beta greater than 1 indicates a stock's price swings more wildly (i.e., more volatile) than the overall market. A beta of less than 1 indicates that a stock's price is less volatile than the overall market. A value less than 1 is good.
Portfolio beta
Measures the risk of the well-diversified portfolio by measuring the Beta of the overall portfolio. Aids in determining performance (return) relative to risk of a portfolio. See how assets contribute to the overall risk of a portfolio.
The expected rate of return on an investment depends upon two things:
Basic compensation for waiting (risk-free return), An investment-specific risk premium
Capital asset pricing model (CAPM)
A financial model that calculates the expected rate of return for an asset or investment. Models the “well diversified” investors trade-off between risk and return
CAPM assumptions
All investors are risk-averse by nature. Investors have the same time period to evaluate information. There is unlimited capital to borrow at the risk-free rate of return.
