Capital Budgeting

Flashcards on Capital Budgeting

Capital Budgeting

The process of making capital expenditure decisions in business. Involves choosing among various projects to find the one(s) that will maximize a company’s return on its financial investment

Estimated cash inflows and outflows

Preferred for inputs into the capital budgeting decision tools.

The capital budgeting decision, under any technique, depends in part on a variety of considerations

• The availability of funds.

• Relationships among proposed projects.

• The company’s basic decision-making approach.

• The risk associated with a particular project.

Methods of evaluating capital investment projects that do not consider the time value of money

Payback Period and Accounting Rate of Return

Methods of evaluating capital investment projects that consider the time value of money

Net Present Value (NPV), Profitability Index (PI), and Internal Rate of Return (IRR)

Payback Period formula when net annual cash flows are equal

Cost of Capital Investment ÷ Net Annual Cash Flow

The shorter the payback period, the more attractive the investment.

The cash payback technique recognizes that

• The earlier the investment is recovered, the sooner the company can use the cash funds for other purposes.

• The risk of loss from obsolescence and changed economic conditions is less in a shorter payback period.

Net Annual Cash Flow

Computed by adding back depreciation expense to net income. Depreciation expense is added back because it is an expense that does not require an outflow of cash.

Main Shortcoming of the cash payback technique

It ignores the expected profitability of the project.

Annual Rate of Return Formula

Expected Annual Net Income ÷ Average Investment

The higher the rate of return for a given risk, the more attractive the investment.

Decision rule for Accounting Rate of Return

A project is acceptable if its rate of return is greater than management’s required rate of return.

Major limitation of Accounting Rate of Return Method

It does not consider the time value of money.

Net Present Value (NPV) Method

Discounting net cash flows to their present value and then comparing that present value with the capital outlay required by the investment. The primary discounted cash flow technique. The higher the positive net present value, the more attractive the investment

Assumptions of Net Present Value Method

• All cash flows come at the end of each year

• All cash flows are immediately reinvested in another project that has a similar return

• All cash flows can be predicted with certainty.

Profitability Index Formula

Present Value of Future Cash Flows ÷ Initial Investment

The higher the profitability index, the more desirable the project.

Internal Rate of Return (IRR) Method

Finds the interest yield of the potential investment. The interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected net annual cashflows. Determining this can be done with a financial (business) calculator, computerized spreadsheet, or by employing a trial-and-error procedure.

Present Value Factor for Internal rate of return

Net investment cost / Net cash inflows

Intangible Benefits

Difficult to quantify, and thus often are ignored in capital budgeting decisions.

Example: increased quality, improved safety, or enhanced employee loyalty

Sensitivity Analysis

Uses a number of outcome estimates to get a sense of the variability among potential returns. In general, a higher risk project should be evaluated using a higher discount rate.

Post-Audit

A thorough evaluation of how well a project’s actual performance matches the projections made when the project was proposed. Involves the same evaluation techniques that were used in making the original capital budgeting decision—for example, use of the net present value method. The difference is that, in the post-audit, actual figures are inserted where known, and estimation of future amounts is revised based on new information.

Importance of Performing a Post-Audit

• Since managers know that their results will be evaluated, there is an incentive for them to make accurate estimates rather than presenting overly optimistic estimates in an effort to get projects approved.

• A post-audit provides a formal mechanism for determining whether existing projects should be continued, expanded, or terminated.

• Post-audits improve future investment proposals because managers improve their estimation techniques by evaluating past successes and failures.

Capital budgeting evaluation process steps

1. Project proposals are requested from departments, plants, and authorized personnel.

2. Proposals are screened by a capital budget committee.

3. Officers determine which projects are worthy of funding.

4. Board of directors approves capital budget.

Commonly Used Methods of Evaluating Capital Investment Projects

• Payback Period

• Accounting rate of return

• Net present value (NPV)

• Profitability Index (PI)

• Internal Rate of Return (IRR

In the case of uneven net annual cash flows

The company determines the cash payback period when the cumulative net cash flows from the investment equal the cost of the investment.

Cash payback technique advantages

Relatively easy to compute and understand.

Annual rate of return method

Based directly on accounting data rather than on cash flows.

Accounting rate of return

Management compares the annual rate of return with its required rate of return for investments of similar risk

Required rate of return

Generally based on the company’s cost of capital.

Accounting rate of return advantages

The simplicity of its calculation and management’s familiarity with the accounting terms used in the computation.

Discounted cash flow techniques

Generally recognized as the most informative and best conceptual approaches to making capital budgeting decisions. These techniques consider both the time value of money and the estimated net cash flow from the investment.

Discount rate or required rate of return.

Company management determines what interest rate to use in discounting the future net cash flows. This rate is often referred to as the _______.

Net present value decision rule

A proposal is acceptable when net present value is positive, because this means the rate of return on the investment equals or exceeds the discount rate (required rate of return).

Cost of capital

The rate that the company must pay to obtain funds from creditors and stockholders.

Companies rarely are able to adopt all positive-NPV proposals because

1. The proposals are mutually exclusive (if the company adopts one proposal, it would be impossible to also adopt the other proposal).

2. Companies have limited resources.

Profitability index decision rule

The project with the greater profitability index should be the one chosen.

Profitability index

A method that compares the relative merits of alternative capital investment projects.

Internal rate of return decision rule

Accept the project when the internal rate of return is equal to or greater than the required rate of return. Reject the project when the internal rate of return is less than the required rate.

To avoid rejecting projects that should actually be accepted, managers can either

• Calculate the net present value (NPV) ignoring intangible benefits, and if the resulting NPV is negative, evaluate whether the intangible benefits are worth at least the amount of the negative NPV.

• Incorporate intangible benefits into the NPV calculation by projecting rough, conservative estimates of their value. If, after using conservative estimates, the net present value is positive, the project should be accepted.