Week 1

Assumptions in Capital Budgeting

-Accounting profits equal cash flows

- Asset is depreciated straight line over project’s life

-All cash flows occur at end of year

NPV cash flow formula picture

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What does r stand for in NPV formula?

Discount rate/required rate of return

What does Time Value of Money allow?

Future values to be discounted( translated into today's money) at the required rate of return subtracting the initial investment

What is the generalised formula for NPV?

- initial investment + cash flows discounted

If NPV is more than 0 is it worth pursuing?

Yes as it is profitable

If comparing two Positive NPVs which is preferred?

The highest positive NPV

In a mutually exclusive project which is prioritized higher NPV or higher IRR?

Higher NPV

What is Payback period?

How long it takes a company to recover its initial investment

If an investment takes longer for it to be paid back what does this mean?

It is more risky

What does a positive NPV mean for IRR?

IRR is higher than cost of capital/discount rate

What does a negative NPV mean for IRR?

IRR is lower than capital/discount rate

What should you do for residual value in last year of cash flow?

Add it to the last year of cash flow

Differentiation of accounting vs finance profit from cash flows?

Accounting focus on periodic performance versus finance focus on cash coming in and cash going out

What do accounts focus on then just cash?

Money earned over cash so we need to adjust accounting profits to calculate actual operating cash flows

Is tax depreciation = accounting depreciation?

No

When is tax paid for “small” companies?

9 months after year-end

When is tax paid for “large” companies?

Quarterly basis

Common assumption in capital budgeting?

Tax is paid in year during which it arises or one year later

What is straight line depreciation?

An expense spread out evenly over the assets useful life

Formula for straight line depreciation?

1/useful life in years * (asset cost- residual value)

Example question

Moga’s toy manufacturing is considering the purchase of a new machine facility for £120,000. The facility is to be fully depreciated on a straight-line basis for tax and accounting purposes over its expected 6 year useful life and will have no resale value in year 6. Assume tax is paid during the year in which it arises and the corporate tax rate is 30%.

• Operating revenues from the project are expected to be £50,000 in each year and production costs are expected to be £20,000 in each year. Should the company undertake the project if the opportunity cost of capital is 20%?

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What is the 3 steps in capital budgeting?

-1.Calculate annual tax depreciation allowances

-2.Calculate accounting profit each year

-3.Calculate NPV

What is tax depreciation set by?

The government

Is tax depreciation a cash flow?

No

What is the tax depreciation?

-Tax depreciation (in our context) will be an annual accounting charge for using an asset

What is the final year charge in capital budgeting?

Difference between written down(machinery) value and resale value

How do you calculate annual profit?

Income statement

What is IRR?

Discount rate when NPV=0

What is net cash flow for a project?

-After-tax cash flows from operations

-Cash flows from working capital

-Cash flows from investment

What does IRR have to be in comparison to discount rate r to make project worth pursuing?

IRR should be more

Cash flow schedule

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What is a perpetuity?

An infinite stream of equal cash flows that occur at regular intervals and continue forever

Formula of a zero growth perpetuity?

Cash flow/ Discount rate ( C/r)

What is a growing perpetuity

An infinite stream of cash flows that continue forever, but increase by a constant percentage each period

Formula of a growing perpetuity

PV = C1 / r-g

C1 - The expected cash flow in the very next period (Year 1).

r - The discount rate, cost of capital, or required rate of return.

g - The constant growth rate at which the cash flow increases each year.