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Date Created: 11/01/15
Chapter 9 Capital Budgeting and Cash Flow Analysis 1 Capital budgeting is the process of planning for capital expenditures which are de ned as cash outlays expected to generate a ow of future bene ts lasting longer than one year 11 Capital budgeting analysis is a two step processiestimating cash ows initial and net cash ows and evaluating whether the project is Viable or not that is whether it is pro table or not Cash ow estimation is covered in chapter 9 while evaluation of project pro tability is discussed in chapter 10 111 Principles of estimating cash ow Cash ows should be measured on an incremental basis Cash ows should be measured on an after tax basis Changes in net working capital should be included in the determination of cash ows All indirect effects of a project should be included in cash ow estimation e g cannibalization Sunk costs should be ignored Value of resources used in a project should be based on their opportunity costs IV Estimating cash ows for a new businessisee example in textbook beginning on page 267 V Estimating cash ows for a replacement projectisee example starting on page 273 111 Chapter 5 Lecture Notes Time Value of Money Importance of time value of money 1 Most problems in nance deal with comparing cash ows over time 2 TVM is important for the following future topics a Valuation of securities and other assets b Capital budgeting c Cost of capital Concept of future value present value and interest rate aka discount rate compound rate opportunity rate Future value of a single cash ow Years 0 1 l l 1000 FVI Fv1 We 1 1 1000 1 006 1000 60 1060 Fv PV01 1quot 56 Note the equation has 4 variables therefore given any three variables you should be able to compute the fourth variable Future value problems can also be solved on a financial calculator Present value of a single cash ow i5 Years 0 1 2 3 4 5 P31 25520 Equation 56 can be expressed in terms of the present value as PVO FVn 1 n 58 1 i Future value of uneven cash ows Years 100 200 300 VI Future value of an annuity Ordinary annuity Years PMT11000 PMT21000 PMT31000 I FVAN3 139 6 Annuity due Present value of an uneven stream VII Years 0 1 2 3 100 200 300 PVO VIII Present value of an annuity Ordinary annuity Years 0 1 2 3 4 i 1000 l000 1000 1000 1000 139 6 PVAN34212 Annuity due IX Present value of perpetuity PMT 516 139 PVPERO X Effect of compounding frequency on 1 Effect on present and future value of a single sum 2 Effect on present and future value of annuities 3 Effective interest rates 1 1L 1 521 m XI Loan amortization problem Chapter 15 Longterm and shortterm planning 1 Some definitions Strategic planning deals with the big picture issues where is the industry headed What should the company look like in 10 years 20 years Etc Operation planning long term 5 year and short term 12 years It details the operational objectives which are very specific and the resources needed to achieve the objectives Financial plans are an integral and important part of the operation plan Financial plans consist of pro forma financial statements and cash budgets The purpose of these plans is to ensure that the firm has adequate financial resources or to make the necessary arrangements to meet the operational objectives ll Pro forma financial statements 0 Percent of sales method Under this method the income statement and balance sheet are projected by assuming that most items assets current liabilities expenses move proportionally with sales The income statement is projected first and then the balance sheet In the balance sheet a plug figure a liability account is used to balance the balance sheet and tells you how much additional financing is needed See example in textbook page 429 and related discussion lllCash budget 0 Provides more detailed forecasts of how the company s cash will be spent on labor materials and capital goods and how the cash will be obtained 0 Pro forma financial statements are more long term in nature annual for example while cash budgets are used to plan for the short term 12 mos18 mos for example Cash budgets may also be projected weekly or daily for the very short term See example in textbook page 437 and related discussion IV Risk analysis Risk analysis should be a part of any planning Planningforecasts are based on assumptions Sensitivity analysis whatif analysis and scenario analysis should be part of the planning exercise so that adequate contingency plans can be made Chapter 10 Lecture Outline Capital Budgeting Decision Criteria and Risk Analysis Some basic concepts 0 Independent projects vs mutually exclusive projects An independent project is one whose acceptance or rejection does not directly eliminate other projects from consideration A mutually exclusive project is one whose acceptance precludes the acceptance of one or more alternative proposals Availability of funds capital rationing or funds constraint 0 Cost of capital is the cost of funds to a rm It serves as the hurdle rate or required rate of return in evaluating capital budgeting proposals Net present value NPV NPV is the present value of the streams of net cash ows from a project minus the projects net investment NPV f NCFt NINV t11kt 101 A project should be accepted if the NPV is gt or 0 A NPV means that the returns from the project are greater than the required rate of return cost of capital The NPV tells you by how much shareholder wealth will increase if a particular project is accepted 111 Internal rate of return IRR IRR is the discount rate that equates the present value of the net cash ows from a project with the present value of the net investment In other words IRR is the discount rate that causes a project s net present value to equal zero The internal rate of return for a capital expenditure project is conceptually similar to the yield to maturity for a bond investment that we covered in Chapter 7 A project s internal rate of return can be determined by solving for r in the following equation 02quot NCF NINV 1 10 103 A project is acceptable if the IRR is greater than or equal to the cost of capital k 0 While the NPV and IRR are based on the same underlying principles discounted cash ow model the IRR has at least 2 potential problems 0 Multiple internal rates of returns 0 Different reinvestment rate assumption for different projects leading to con icting rankings Project L Project M NINV 1000 1000 NCF Year 1 667 0 Year 2 667 1400 NPVat 5 240 270 IRR 215 183 0 Despite the problems with IRR it is more widely used than NPV because it is easier to related to compared to NPV IV Pro tability Index The pro tability index P1 or bene tcost ratio is the ratio of the present value of expected net cash flows over the life of a project to the net investment ZNCE 1 k 21 P 108 NIN V V Payback period The payback period PB of an investment is the period of time required for the cumulative net cash flows from a project to equal the net investment VI Adjusting for risk 0 The cost of capital of the rm is the appropriate hurdle rate for projects that are of risk similar to the average project of the rm For more or less risky projects an appropriate risk adjusted discount rate should be used 0 More on risk analysis 0 Whatif or sensitivity analysis 0 Simulation analysis 0 Real options 0 In ation and capital budgeting
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