CH 7: Capital Budgeting

The process that companies use when considering projects that (1) involve the potential acquisition of a long-term tangible or intangible asset, (2) require significant cash inflows and outflows, (3) span a long-term time horizon, and (4) achieve economic benefits in the form of a target return

Capital Budgeting

The choice of where to place dedicated monies to earn a return

investment decision

Investing cash, perhaps with an advisory firm to monitor its growth, and letting it grow without active, daily management

passive investing

What are the 5 steps in the Circle of Life of a business

Stockholders/lenders provide cash
Comp buys productive assets
Comp uses productive assets to make profit/return
Comp uses cash from operations for any purpose
Cash is directed to stockholders and lenders

The percentage return for each dollar invested

ROI

ROI=

Return / Investment

What is the return for calculating ROI for cost accounting purposes?

Operating Income

What is the return for calculating ROI for financial accounting purposes?

Net income

Why does financial accounting use NI for return instead of operating income?

They want to capture all transactions

What is meant by investment for ROI (main 3 companies use)

Total assets
Operating assets
LT assets

What are the 6 elements that comprise capital budget decisions?

timelines
TVM
Cash Flows
Discount Rates
Tax Rates
Depreciation Tax Shield

The concept that money is worth more now than the same amount at a future time because of its earning potential, starting today

TVM

Occurs when interest is added to an amount and the new larger sum continues to earn interest and grows even more

compounding

What is the FV of a single sum that is compounded? FV=

PV (1+r)^n

Modifying the compounding formula to reduce a known future value to today’s dollars, based on a given interval of time and rate of return

discounting

The value in today's dollars of a given future value

PV

PV=

FV / (1+r)^n

FV ordinary anuity =

(PMT * ((1+r)^n - 1))/ R

A generic term commonly used interchangeably for WACC, RRR, target rate of return, and hurdle rate

Discount Rate

The tax savings, translated into cash flows, that result from tax-deductible expenses

tax shield

What gives a tax shield

depreciation expense

Depreciation Tax Shield=

annual dep exp * Tax rate = Tax Savings

What are the methods for evaluating the capital budget? (5)

NPV
IRR
Payback Period
ARR
Profitability Index

NPV is only useful if the:

CF estimates are reasonable

NPV assumes that each years return is reinvested at:

the same rate (the discount rate)

Captures the value of the surplus (or deficit) a project generates for shareholders, in todays dollars, above (or below) the firms RRR; easily accommodates nonuniform CFs as they happen from year to year throughout project’s life; can also be used to rank competing projects with similar initial investment amounts

NPV

If a projects NPV is positive, the return of the project is:

>RRR

If a projects NPV is negative, the return of the project is:

<RRR

If a projects NPV is zero, the return of the project is:

=RRR

The rate that equates the NPV of a project’s after-tax cash outflows with the NPV of its after-tax cash inflows

IRR

A project is more desirable when:

IRR is higher

The amount of time (typically in years) that it takes a project to earn a cash return equal to its up-front investment cost

Payback Period

Simple payback period=

Net initial investment / annual CFs

The amount of time (typically in years) that it takes to earn a cash return equal to its up-front investment cost, putting all cash flows into present value terms

discounted payback periods

The averaged annual after-tax operating income earned by a project over its lifespan, divided by the net initial investment

Accounting Rate of Return (ARR)

Considered the accounting version of ROI; considered the projects impacts on accrual accounting income, rather than just CFs

ARR

ARR=

Averaged annual after tax operating income earned over projects life / net initial investment

The ratio of the present value of a project’s net future cash flows to the project’s net initial investment

profitability index

Profitability index =

project’s PV of future cash flows / net initial investment

The process of looking at a variety of “what-if” scenarios and their outcomes

sensitivity analysis

What are the methods needed to follow up after a capital budget decision and its implementation?

post investment audits and performance evaluations

An analysis conducted in order to detect problems and compare expectations to reality after an investment decision has been made and implemented

post investment audit