November 26, 2014

Chapter 11. Capital Assets - Projects - Proposals Appraisal



Chapters 11. Capital Budgeting



. Capital budgeting
. Project classifications
. Capital budgeting techniques
. Cash flow estimation
. Risk analysis in capital budgeting
. Optimal capital budget






. Capital budgeting


 Strategic business plan: a long-run plan that outlines in broad terms the firm’s
basic strategy for the next 5 to 10 years



 Capital budgeting: the process of planning expenditures on assets with cash flows

 that are expected to extend beyond one year





. Project classifications


Replacement Projects:

Need to continue current operations

Need to reduce costs



Expansion Projects:

Need to expand existing products or markets

Need to expend into new products or markets



Others: safety/environmental projects, mergers





. Capital Assets - Projects Appraisal techniques


 (1) Net present value (NPV): present value of future net cash flows, discounted at  the cost of capital

 , where r is the cost of capital, CFt is the cash flow in time t ..
.
.




 (2) Internal rate of return (IRR): rate of return a project earns (a discount rate that forces a project’s NPV to equal zero)

 ..
.
.
.


 Problems associated with IRR:

 Multiple rates of return and unrealistic reinvestment rate assumption




 (3) Modified internal rate of return (MIRR): discount rate at which the present value of initial cost is equal to the present value of the terminal value



 (4) Payback period: the length of time (years) required for an investment’s cash flows to cover its cost



 (5) Discounted payback period: the length of time (years) required for an investment’s cash flows, discounted at the investment’s cost of capital to recover its cost





 Decision rule: if NPV > 0, accept the project; if NPV < 0, reject the project


 Independent vs. mutually exclusive projects



 Independent projects are projects with cash flows that are not affected by the acceptance or rejection of other projects



 Mutually exclusive projects are a set of projects where only one can be accepted




 In general, you should choose the project with the highest positive NPV



 If they are independent, you choose all projects with NPV  > 0








Decision rule: if IRR > r, accept the project; if IRR < r, reject the project

where r is the hurdle rate (the required rate of return for the project)



 Multiple IRRs: the situation where a project has two or more solutions (or IRRs)



 Reinvestment rate assumptions: NPV approach is based on the assumption that
cash flows can be reinvested at the project’s risk-adjusted WACC, where the IRR
approach is based on the assumption that cash flows can be reinvested at the
project’s IRR






(3) MIRR approach






(1) Compound each future cash inflow to the “terminal year”, using WACC

(2) Add all the future values to get “terminal value”

(3) Calculate I/YR to get MIRR



Decision rule: if MIRR > r, accept the project; if MIRR < r, reject the project

where r is the hurdle rate (the required rate of return for the project)






 NPV profile: a graph that shows the relationship between a project’s NPV and the firm’s cost of capital






  Crossover rate: the cost of capital at which the NPV profiles of two projects cross and thus, at which the projects’ NPVs are equal



  Ranking problem (conflict): NPV approach and IRR approach sometimes will
lead to different rankings for mutually exclusive projects





 If ranking problem occurs use NPV approach to make the final decision



 Main conditions to cause conflicts

 a. Timing of cash flows

 b. Scale of cash flows



 (4) Payback period approach



 Decision rule:

If payback < maximum payback, then accept the project

If payback > maximum payback, then reject the project



 Weaknesses:

 Arbitrary maximum payback

 Ignores time value of money

 Ignores cash flows after maximum payback period


 (5) Discounted payback period approach



Step 1: discount future cash flows to the present at the cost of capital (round to the
nearest whole dollar)

Step 2: follow the steps similar to payback period approach



 Decision rule: similar to that of payback period



Weaknesses:

 Arbitrary maximum discounted payback period

 Ignores cash flows after maximum discounted payback period





. Cash flow estimation


 Guidelines when estimating cash flows:

 Use after tax cash flows

 Use increment cash flows

 Changes in net working capital should be considered

 Sunk costs should not be included

 Opportunity costs should be considered

 Externalities should be considered

 Ignore interest payments (separate financing decisions from investment decisions)



 FCF = [EBIT*(1 - T) + depreciation] – [capital expenditures + NOWK) .



 EBIT*(1 - T) = net operating profit after tax = NOPAT

 NOWK = change in net operating working capital



Steps in estimating cash flows:

(1) Initial outlay

 (2) Differential (operating) cash flows over project’s life

 (3) Terminal cash flows

 (4) Time line and solve


MBA Core Management Knowledge - One Year Revision Schedule


















No comments:

Post a Comment