FINA 3332 Ch 9 Capital Budgeting Techniques

capital budgeting

the process of financially evaluating expenditures on projects whose cash flows are expected to extend beyond one year

long term assets & fixed assets

independent projects

projects not affected by decisions made about other projects

mutually exclusive projects

a set of projects where the acceptance of one projects means the others cannot be accepted

cash flow methods

payback

discounted payback (DPB)

net present value (NPV)

internal rate of return (IRR)

payback period

the length of time it takes to recover the original cost of an investment from its expected cash flows

PB decision rule

a project is acceptable if payback of original investments occurs within the time frame required by the company

discounted payback period

payback period that considered the time value of money

is the length of time it takes for a project’s discounted cash flows to repay the cost of the investment

DPB decision rule

a project is acceptable if this is less than the company’s requirement

advantages to payback period methods

-easy to understand

-gives measure of the project’s liquidity

-gives approximation of project’s risk

disadvantages to payback period methods

firms arbitrarily set payback period

ignores cash flows beyond the payback period

net present value

the most correct way of measuring a capital expenditure project

measures how much value a project contributes in today’s dollars

tells whether the project will increase the wealth of the company’s owners after accounting for the time value of money and the cost of capital (required rate of return)

if npv is positive

the project is expected to add value to the firm

it generates more than the required return and should be accepted

if npv is negative

the project destroys value and should be rejected

if npv is zero

the project earns exactly the required return, neither adding nor destroying value

mutually exclusive

when choosing between projects, means you can only take one

take the one with the highest NPV

independent

when choosing between projects, means any and all can be taken

take the one with a positive NPV

internal rate of return (IRR)

at what rate must the cash flows be discounted so that the sum of the discounted cash flows is equal to the initial outflow

is the average rate of return earned over the life of the project

accept

if the IRR is greater than the firm’s required rate, ____ the project

amount and timing

what of cash flows impact IRR

further

the ____ away the cash flows, the longer the IRR

larger

the ____ the cash flows, the higher the IRR

positive

if a project’s IRR is greater than the firm’s required rate the project will have a _____ NPV

stockholders’ returns

if project’s IRR is greater than required rate of return, then some return is left over to boost __________

NPV method

reinvesting at firm’s required rate of return is more realistic, so ____ is better

unrealistic

IRR assumes reinvestment of project’s cash flows at IRR so may be _____

conventional CF pattern

cash outflows at the beginning of the project’s life followed by cash inflows

unconventional CF pattern

cash outflows at the beginning of the project’s life followed by cash inflows followed by at least one additional cash outflow

leads to multiple IRR solutions