How will the firm's total after-tax cash flows change if the new project is accepted?

Save this PDF as:

Size: px
Start display at page:

Download "How will the firm's total after-tax cash flows change if the new project is accepted?"

Transcription

1 NPV and Capital Budgeting: A Short Note on Estimation of Project Cash Flows (Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics) KC Chow The most important value-driving decisions for a firm (and its shareholders) are investment decisions. While it is possible for a firm to get into trouble if it keeps making poor financing and working capital management decisions, its value is mainly determined by the prospects of its long-term investments. Investments by firms can take one of two forms: the purchase of external, already-existing assets (mergers and acquisitions, i.e. M&As) and internally generated investment projects. Capital budgeting is the process of analyzing (more precisely, identifying and valuing 1 ) potential investment projects. There are three major inputs into capital budgeting that determine the usefulness of the analysis: 1) Investment decision rules (e.g., NPV, IRR and Payback Period methods) 2) Project cash flows 3) Project cost of capital (the interest rate used to discount the project s cash flows to determine its value 2 ) It follows that investment decisions made with appropriate investment decision rules, but with poor estimations on project cash flows and the discount rate, could still destroy shareholders value. This short note discusses a framework that can be used to identify and estimate the cash flows (NOT accounting income) arising from a capital budgeting project. An example, together with detailed answers, is provided to help AAT Examination Paper 4 candidates to gain hands-on experience in handling this topic in the examination. How will the firm's total after-tax cash flows change if the new project is accepted? The key to a new project s cash flows (CFs) is to think incrementally. Basic economics informs us that a correct decision can only be made if all marginal benefits and marginal costs of an action (including investment activities) are considered in the decision-making process. In the context of capital budgeting, this can be captured by the following relationship: CFs (Project) = CFs (Firm with the project) CFs (Firm without the project) 1 Valuing is done by estimating the present value of the expected cash flows from the project. 2 Project cost of capital is also commonly known as the required rate of return of the project, which essentially is determined by the risk of the project. 1

2 These project-related cash flows are known as incremental cash flows (cash flows arising from the project). Incremental cash inflows (outflows) should show up as a positive (negative) value on the left-hand side of the equation above. If the cash flows occur regardless of whether the project is undertaken (non-incremental), then CFs (Project) will be equal to zero. In determining the project s incremental cash flows, it would be helpful to keep the following principles in mind: i) Do NOT include sunk costs: Costs that have already been incurred or money that has already been committed are irrelevant; only cash flows that are incurred now and/or in the future matter. Examples of sunk costs: Consultation fee for a feasibility study of the project Past research and development expenditures. To see how the equation above can be used to determine the incremental cash flows for the project, assume that the consultation fee for the feasibility study above is \$0.5m. It follows that CFs (Project) = 0 = [ \$0.5m (cash flows to the firm with the project judged as feasible)] [ \$0.5m (cash flows to the firm with the project judged as infeasible)] ii) Include opportunity costs: Any asset used for a project might have a higher value in some alternative use. Example: Let the relevant market interest rate r be 10%. A piece of land owned by the firm is to be used to build a new plant on. The piece of land could be sold for \$10m now (if the project is not undertaken) or \$15m at the end of the project period, in 10 years. NPV of foregone opportunity = \$10m + m ( ) - m The above calculations show that, by going ahead with the project, although the firm retains the ownership of the piece of land and reaps the benefits from the rise in the land value during the project, it has incurred an opportunity cost of 10% per year (the return it could have earned by investing the \$10m in financial assets of similar risk to the project) It follows that the opportunity land cost for the project is \$4.22m in today s dollars. iii) Include all side effects: The project may harm or enhance existing businesses (in terms of cash flows) of the firm. iv) Do NOT include financing costs: The costs of financing the project (such as interest payments on debt and dividend payments) have already been embodied in the project cost 2

3 of capital (r). To avoid double counting, financing costs should not be included as part of the project s incremental cash outflows. v) Future inflation (or deflation) must be taken into account when estimating future cash flows of the project, as it would affect not only the incremental cash inflows and outflows, but also the project cost of capital, k. [In this note, inflation will not be considered.] Example: A feasibility study costing \$800,000 commissioned by UShale Mining Inc. (UMI) has concluded that production capacity constraints will be the major hindrance to the firm s development over the next few years The company s board has decided to build a new production facility to increase the firm s production capacity The project is expected to last for 10 years. The following cash flows are estimated for the project: 1) The land which the facility will be built on is estimated to cost \$150 million to acquire and is expected to be worth \$350 million at the end of the project. 2) The construction cost of the production facility is estimated to be \$20 million. For tax purposes, the facility will be fully depreciated on a straight line basis over its estimated economic life of 10 years and is expected to be sold for \$4 million at the end of the project. 3) Machinery will have to be purchased for the production facility at a cost of \$10 million. For tax purposes, machinery will be depreciated at its full cost on a straight-line basis over its estimated economic life of 10 years. The machines are expected to be sold for \$1 million at the end of the project. 4) An initial increase in working capital of \$500,000 is required today and another \$750,000 at the end of Year 4 and Year 7, respectively. The working capital will be fully recovered at the end of the project. 5) To fund the project, UMI has borrowed \$100 million from the bank and the yearly interest charge is 5%. The management of UMI estimates that the project will increase revenues and operating expenses (before depreciation and amortization) by \$8 million and \$3 million respectively in its first three years of operation and \$12 million and \$5 million respectively in the remaining seven years. UMI s corporate income tax rate is project, given its risk) is 10%. % and its cost of capital (required rate of return of the Based on the net present method, should the project be undertaken? 3

4 How to handle the cash flows from the project to arrive at an NPV estimate for the project: This framework is based on the cash flows timeline of the project: a) Initial Investments (Investment outlays at the beginning of the project, t = 0) e.g. Investments on land, machinery, equipment, production facility and change in net working capital. b) Present Value (PV) of the Net Cash Flows over the life of the project i) PV of yearly after-tax cash flows from operations (assuming cash flows are the same every year) = Yearly after-tax operating CFs PVIFA (m,k) where m is the economic life of the project and k is the project cost of capital Note: If there is no corporate income tax, there is no difference between before-tax and after-tax cash flows. ii) PV of yearly tax savings from depreciation of the assets (based on the straight-line depreciation method and the asset being fully depreciated) = Yearly depreciation expense (D = ) tax rate (T) PVIFA (m, k) where n is the economic life of the asset Note: If there is no corporate income tax, T is equal to zero, and there will be no tax savings from depreciation of the assets. This item can be ignored completely. iii) PV of after-tax salvage value of the assets received at the end of the project = After-tax salvage value x PVIF (m,k) 1) After-tax (AT) salvage value of Depreciable Asset i = Resale Price Corporate Income Tax owed (if any) = Resale Price (Resale Price Remaining Book Value t = m) x Tax Rate (T) = Resale Price (Resale Price (Initial Cost Accumulated Depreciation at the end of the project)) T = Resale Price [Resale Price (Initial Cost x m)] x T Note: If the economic life of the project is the same as that of the asset (i.e., m = n), the formula above could be simplified to the following: AT salvage value of Depreciable Asset i = Resale Price (1 T) 4

5 2) After-tax (AT) salvage value of Non-Depreciable Asset i (e.g. land) * = Resale Price Capital Gains Tax (if any) = Resale Price (Resale Price Purchase Price) x T Note: If there is no capital gains tax, AT salvage value of Non-Depreciable Asset i = Resale Price iv) PV of the recovered net working capital = The amount of NWC recovered PVIF (m,k) v) PV of any other one-off cash flows expected to be received/paid at the end of the project (e.g., the after-tax clean-up cost of a coal mine incurred at the end of the project) Note: As mentioned earlier, financing costs such as interest payments and dividends should NOT be included as part of the incremental cash flows in the calculation of the NPV of the project. c) NPV of the project = (b) (a) NPV > 0 Accept the project NPV < 0 Reject the project 5

6 Suggested answers (a) Initial costs of investment: \$ Land 150m Production facility 20m Machinery 10m PV of working capital m (\$0.5m + \$0.75m PVIF (n=4, k=10%) + \$0.75m PVIF (n=7, k=10%) ) Total \$ m (b i ) PV of yearly after-tax cash operating income = (\$8m \$3m)(1 0.2) x PVIFA (m=3, k=10%) + (\$12m \$5m)(1 0.2) PVIFA (m=7, k=10%) PVIF (m=3, k=10%) 3 = \$9.9474m + \$ m = \$ m (b ii ) PV of yearly tax savings from the depreciation 4 of Production facility = (\$20m/10 0.2) PVIFA (m=10, k=10%) = \$2.4578m Machinery = (\$10m/10 0.2) PVIFA (m=10, k=10%) = \$1.2289m Sub-total = \$3.6867m (b iii ) PV of after-tax salvage value of Land = \$350m PVIF (m=10, k=10%) = \$ m* Production facility = \$4m x (1 0.2) PVIF (m=10, k=10%) = \$1.2337m 5 Machinery = \$1m (1 0.2) PVIF (m=10, k=10%) = \$0.3084m 6 Sub-total = \$ m Note: Although it is likely that all or some of the assets may be kept by the firm for other uses, project analysis (NPV analysis, in this case) requires that they be treated as sold at the market value at the end of the project. 3 If there is no corporate income tax, PV of cash operating income ( 8m 3m) PVIFA (m=3,k=10%) + ( m m) PVIFA (m=7,k=10%) PVIF (m=3, k=10%) 4 If there is no corporate income tax, there will be no tax savings from depreciation of the assets. The calculations in (b ii ) could be ignored completely. 5 With no corporate income tax, the PV of the salvage value of the production facility = \$4m PVIF (m=10, k=10%) 6 With no corporate income tax, the PV of the salvage value of the machinery = \$1m PVIF (m=10, k=10%) 6

7 * Combined with the m purchase price in (a), the opportunity land cost in today s dollar = \$150m + \$ m = (\$ m) (as explained on p.2) (biv) PV of the fully recovered net working capital = (\$0.5m + \$0.75m + \$0.75m) PVIF (m=10, k=10%) = \$0.7710m** ** Combined with the \$1.3972m working capital cost in (a), the opportunity cost of the working capital for the project = -\$ \$0.7710m = (\$0.6262m) Total [(b i ) + (b ii ) + (b iii ) + (b iv ) = \$ m Note: The 5% yearly interest on the \$100m loan (item (5) in the question) should be ignored since, as a financing cost of the project, it has been already been incorporated in the 10% project cost of capital given in the question. (c) NPV = (b) (a) =\$ m \$ m = (\$ m) < 0 Since the project s NPV is less than zero, reject the project Conclusion This teaching note on estimating capital budgeting project cash flows has made several simplifying assumptions that are worth explicitly mentioning at the end of this article. The assumptions include the following: 1) Operating cash flows are assumed to be fixed every year, and thus can be treated as an ordinary annuity. 2) The straight-line depreciation method is adopted even though most firms would tend to use some sort of accelerating methods to reap the greatest tax saving benefits from the depreciation of the assets. 3) In estimating the opportunity land cost of the project, it was assumed that the piece of land is not yet owned by the firm. This assumption made the calculation of the after-tax salvage value of land and the underlying concepts much easier to handle. 7

CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS

CHAPTER 10 MAKING CAPITAL INVESTMENT DECISIONS Answers to Concepts Review and Critical Thinking Questions 1. In this context, an opportunity cost refers to the value of an asset or other input that will

CHAPTER 7 MAKING CAPITAL INVESTMENT DECISIONS

CHAPTER 7 MAKING CAPITAL INVESTMENT DECISIONS Answers to Concepts Review and Critical Thinking Questions 1. In this context, an opportunity cost refers to the value of an asset or other input that will

CHAPTER 7: NPV AND CAPITAL BUDGETING

CHAPTER 7: NPV AND CAPITAL BUDGETING I. Introduction Assigned problems are 3, 7, 34, 36, and 41. Read Appendix A. The key to analyzing a new project is to think incrementally. We calculate the incremental

Chapter 9. Year Revenue COGS Depreciation S&A Taxable Income After-tax Operating Income 1 \$20.60 \$12.36 \$1.00 \$2.06 \$5.18 \$3.11

Chapter 9 9-1 We assume that revenues and selling & administrative expenses will increase at the rate of inflation. Year Revenue COGS Depreciation S&A Taxable Income After-tax Operating Income 1 \$20.60

Chapter 7: Net Present Value and Capital Budgeting

Chapter 7: Net Present Value and Capital Budgeting 7.1 a. Yes, the reduction in the sales of the company s other products, referred to as erosion, should be treated as an incremental cash flow. These lost

BS2551 Money Banking and Finance

S2551 Money anking and Finance Capital udgeting Capital budgeting techniques are decision rules used by managers when undertaking investment decisions. The best techniques should satisfy the following

Week- 1: Solutions to HW Problems

Week- 1: Solutions to HW Problems 10-1 a. Payback A (cash flows in thousands): Annual Period Cash Flows Cumulative 0 (\$5,000) (\$5,000) 1 5,000 (0,000) 10,000 (10,000) 3 15,000 5,000 4 0,000 5,000 Payback

(Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics)

Capital Budgeting: Net Present Value vs Internal Rate of Return (Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics) Y O Lam Capital budgeting assists decision makers in a

CAPITAL BUDGETING. Net Present Value and Other Investment Criteria

CAPITAL BUDGETING Net Present Value and Other Investment Criteria Net Present Value (NPV) Net present value is the difference between an investment s market value (in today s dollars) and its cost (also

CHAPTER 25. P.25.16 The following data are furnished by the Hypothetical Leasing Ltd (HLL):

CHAPTER 25 Solved Problems P.25.16 The following data are furnished by the Hypothetical Leasing Ltd (HLL): Investment cost Rs 500 lakh Primary lease term 5 years Estimated residual value after the primary

1.1 Introduction. Chapter 1: Feasibility Studies: An Overview

Chapter 1: Introduction 1.1 Introduction Every long term decision the firm makes is a capital budgeting decision whenever it changes the company s cash flows. Consider launching a new product. This involves

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Basic 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After two years, the

Finance 445 Practice Exam Chapters 1, 2, 5, and part of Chapter 6. Part One. Multiple Choice Questions.

Finance 445 Practice Exam Chapters 1, 2, 5, and part of Chapter 6 Part One. Multiple Choice Questions. 1. Similar to the example given in class, assume that a corporation has \$500 of cash revenue and \$300

CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING

CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING Answers to Concepts Review and Critical Thinking Questions 1. No. The cost of capital depends on the risk of the project, not the source of the money.

CHAPTER 14 COST OF CAPITAL

CHAPTER 14 COST OF CAPITAL Answers to Concepts Review and Critical Thinking Questions 1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this,

Valuation Free Cash Flows. Katharina Lewellen Finance Theory II April 2, 2003

Valuation Free Cash Flows Katharina Lewellen Finance Theory II April 2, 2003 Valuation Tools A key task of managers is to undertake valuation exercises in order to allocate capital between mutually exclusive

Capital Budgeting Techniques, Project Cash Flows, and Risk

Capital Budgeting Techniques, Project Cash Flows, and Risk 1. Calculate the NPV for the following project. an outflow of \$7,000 followed by inflows of \$3,000, \$2,500 and \$3,500 at one-year intervals at

Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of

1 Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of Return Problems with the IRR Approach The Profitability

CHAPTER 7. Fundamentals of Capital Budgeting. Chapter Synopsis

CHAPTER 7 Fundamentals of Capital Budgeting Chapter Synopsis 7.1 Forecasting Earnings A firm s capital budget lists all of the projects that a firm plans to undertake during the next period. The selection

Chapter 09 - Using Discounted Cash-Flow Analysis to Make Investment Decisions

Solutions to Chapter 9 Using Discounted Cash-Flow Analysis to Make Investment Decisions 1. Net income = (\$74 \$42 \$10) [0.35 (\$74 \$42 \$10)] = \$22 \$7.7 = \$14.3 million Revenues cash expenses taxes paid =

Chapter 7 Fundamentals of Capital Budgeting

Chapter 7 Fundamentals of Capital Budgeting Copyright 2011 Pearson Prentice Hall. All rights reserved. Chapter Outline 7.1 Forecasting Earnings 7.2 Determining Free Cash Flow and NPV 7.3 Choosing Among

Measuring Investment Returns

Measuring Investment Returns Aswath Damodaran Stern School of Business Aswath Damodaran 156 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The

Fast Tools & Resources. Capital Budgeting

Capital Budgeting With this program, the user can evaluate capital budgeting problems and perform comprehensive investment analysis comparisons on up to 4 separate projects or investments. Fast Tools &

Net Present Value and Capital Budgeting. What to Discount

Net Present Value and Capital Budgeting (Text reference: Chapter 7) Topics what to discount the CCA system total project cash flow vs. tax shield approach detailed CCA calculations and examples project

Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows

Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS 13-1 a. The capital budget outlines the planned expenditures on fixed assets. Capital budgeting

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #1 Prof. Simon Gervais Fall 2011 Term 2.

DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #1 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Two years ago, you put \$20,000 dollars in a savings account earning

Valuation. The Big Picture: Part II - Valuation

Valuation The Big Picture: Part II - Valuation A. Valuation: Free Cash Flow and Risk Apr 1 Apr 3 Lecture: Valuation of Free Cash Flows Case: Ameritrade B. Valuation: WACC and APV Apr 8 Apr 10 Apr 15 Lecture:

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project

Chapter 8: Using DCF Analysis to Make Investment Decisions

FIN 301 Class Notes Chapter 8: Using DCF Analysis to Make Investment Decisions Capital Budgeting: is the process of planning for capital expenditures (long term investment). Planning process involves 1-

Chapter 9 Cash Flow and Capital Budgeting

Chapter 9 Cash Flow and Capital Budgeting MULTIPLE CHOICE 1. Gamma Electronics is considering the purchase of testing equipment that will cost \$500,000. The equipment has a 5-year lifetime with no salvage

Chapter 13 Capital Budgeting: Estimating Cash Flow and Analyzing Risk ANSWERS TO END-OF-CHAPTER QUESTIONS

Chapter 13 Capital Budgeting: Estimating Cash Flow and Analyzing Risk ANSWERS TO END-OF-CHAPTER QUESTIONS 13-3 Since the cost of capital includes a premium for expected inflation, failure to adjust cash

Chapter 14 Demonstration Problem Solutions Page 1

Chapter 14 Demonstration Problem Solutions Page 1 Demo 14-1 ANSWER a. First, we need to calculate the tax bill: Year (A) (B) (CA-B) (D.4C) Cash Flow Depreciation Taxable Inc Tx Rate Taxes 1 \$ 100,000 -

TIME VALUE OF MONEY PROBLEM #8: NET PRESENT VALUE Professor Peter Harris Mathematics by Sharon Petrushka

TIME VALUE OF MONEY PROBLEM #8: NET PRESENT VALUE Professor Peter Harris Mathematics by Sharon Petrushka Introduction Creativity Unlimited Corporation is contemplating buying a machine for \$100,000, which

Capital Investment Analysis and Project Assessment

PURDUE EXTENSION EC-731 Capital Investment Analysis and Project Assessment Michael Boehlje and Cole Ehmke Department of Agricultural Economics Capital investment decisions that involve the purchase of

6 Investment Decisions

6 Investment Decisions After studying this chapter you will be able to: Learning Objectives Define capital budgeting and explain the purpose and process of Capital Budgeting for any business. Explain the

Investment Appraisal

Investment Appraisal Article relevant to F1 Business Mathematics and Quantitative Methods Author: Pat McGillion, current Examiner. Questions 1 and 6 often relate to Investment Appraisal, which is underpinned

Project Cost Management

Project Cost Management Guide to Mathematical Questions PMI, PMP, CAPM, PMBOK, PM Network and the PMI Registered Education Provider logo are registered marks of the Project Management Institute, Inc. Present

Which projects should the corporation undertake

Which projects should the corporation undertake Investment criteria 1. Investment into a new project generates a flow of cash and, therefore, a standard DPV rule should be the first choice under consideration.

Part 7. Capital Budgeting

Part 7. Capital Budgeting What is Capital Budgeting? Nancy Garcia and Digital Solutions Digital Solutions, a software development house, is considering a number of new projects, including a joint venture

Planning for Capital Investments

12-1 Planning for Capital Investments Managerial Accounting Fifth Edition Weygandt Kimmel Kieso 12-2 study objectives 1. Discuss capital budgeting evaluation, and explain inputs used in capital budgeting.

Chapter 8: Fundamentals of Capital Budgeting

Chapter 8: Fundamentals of Capital Budgeting-1 Chapter 8: Fundamentals of Capital Budgeting Big Picture: To value a project, we must first estimate its cash flows. Note: most managers estimate a project

Net Present Value (NPV)

Investment Criteria 208 Net Present Value (NPV) What: NPV is a measure of how much value is created or added today by undertaking an investment (the difference between the investment s market value and

CHAPTER 8: ESTIMATING CASH FLOWS

CHAPTER 8: ESTIMATING CASH FLOWS 8-1 a. Straight line depreciation = (\$15 - \$3)/10 = \$1.20 Annual Tax Savings from Depreciation = \$ 1.2 (0.4) = \$0.48 Present Value of Tax Savings from Depreciation = \$

WORKBOOK ON PROJECT FINANCE. Prepared by Professor William J. Kretlow University of Houston

WORKBOOK ON PROJECT FINANCE Prepared by Professor William J. Kretlow University of Houston 2002 by Institute for Energy, Law & Enterprise, University of Houston Law Center. All rights reserved. TABLE

Chapter 6. 1. Your firm is considering two investment projects with the following patterns of expected future net aftertax cash flows:

Chapter 6 1. Your firm is considering two investment projects with the following patterns of expected future net aftertax cash flows: Year Project A Project B 1 \$1 million \$5 million 2 2 million 4 million

Chapter 5 Capital Budgeting

Chapter 5 Capital Budgeting Road Map Part A Introduction to finance. Part B Valuation of assets, given discount rates. Fixed-Income securities. Common stocks. Real assets (capital budgeting). Part C Determination

Capital Budgeting. Finance 100

Capital Budgeting Finance 100 Prof. Michael R. Roberts 1 Topic Overview How should capital be allocated?» Do I invest / launch a product / buy a building / scrap / outsource...» Should I acquire / sell

Capital Budgeting Further Considerations

Capital Budgeting Further Considerations For 9.220, Term 1, 2002/03 02_Lecture10.ppt Lecture Outline Introduction The input for evaluating projects relevant cash flows Inflation: real vs. nominal analysis

Overview of Lecture 9

Overview of Lecture 9 Taxes The Tax Code Calculating after-tax cash flows What Discount Rate to Use? Materials covered: Reader, Lecture 7 BM Chapter 6, pp. 121-134. M. Spiegel and R. Stanton, 2000 1 Review:

The table for the present value of annuities (Appendix A, Table 4) shows: 10 periods at 14% = 5.216. = 3.93 years

21-18 Capital budgeting methods, no income taxes. The table for the present value of annuities (Appendix A, Table 4) shows: 10 periods at 14% 5.216 1a. Net present value \$28,000 (5.216) \$146,048 \$36,048

CAPITAL BUDGETING. Definition. Time Value of Money [TVM] TVM is the reward for postponement of consumption of money.

11 CAPITAL BUDGETING 1LO 1: Time Value of Money Definition Time Value of Money [TVM] TVM is the reward for postponement of consumption of money. Principle Rs.100 received today is greater than Rs. 100

( ) ( )( ) ( ) 2 ( ) 3. n n = 100 000 1+ 0.10 = 100 000 1.331 = 133100

Mariusz Próchniak Chair of Economics II Warsaw School of Economics CAPITAL BUDGETING Managerial Economics 1 2 1 Future value (FV) r annual interest rate B the amount of money held today Interest is compounded

Capital Budgeting OVERVIEW

WSG12 7/7/03 4:25 PM Page 191 12 Capital Budgeting OVERVIEW This chapter concentrates on the long-term, strategic considerations and focuses primarily on the firm s investment opportunities. The discussions

Capital Budgeting continued: Overview:(1) Estimating cash flows (2) CB examples (3) Dealing with uncertainty of cash flows

Capital Budgeting continued: Overview:(1) Estimating cash flows (2) CB examples (3) Dealing with uncertainty of cash flows Chapter 7: 1,5,7,8,27,32 Chapter 8: 1,3,5,8,13 (clarification for problem 13b:

Capital Budgeting: Decision. Example. Net Present Value (NPV) FINC 3630 Yost

Capital Budgeting: Decision Criteria Example Consider a firm with two projects, A and B, each with the following cash flows and a 10 percent cost of capital: Project A Project B Year Cash Flows Cash Flows

Will the future benefits of this project be large enough to justify the investment given the risk involved?

Chapter 1 The Overall Process Capital Expenditures Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase

Chapter 7 Fundamentals of Capital Budgeting

Chapter 7 Fundamentals of Capital Budgeting 7-1. Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats.

Global Financial Management

1 Global Financial Management Valuation of Cash Flows Investment Decisions and Capital Budgeting Copyright 1999 by Alon Brav, Campbell R. Harvey, Stephen Gray and Ernst Maug. All rights reserved. No part

12. What is the Internal Rate of Return for the project? a. 18.52 percent d. 21.79 percent b. 16.95 percent e. 15.55 percent c. 20.

Business Finance Name Examination Four Spring 2005 version 4 Select the best answer for each of the following questions. Mark your selection on the examination and on your scantron. You may also record

Answers to Warm-Up Exercises E11-1. Categorizing a firm s expenditures Answer: In this case, the tuition reimbursement should be categorized as a capital expenditure since the outlay of funds is expected

ICASL - Business School Programme Quantitative Techniques for Business (Module 3) Financial Mathematics TUTORIAL 2A This chapter deals with problems related to investing money or capital in a business

Chapter 14 Notes Page 1

Chapter 14 Notes Page 1 Capital Budgeting This chapter examines various tools used to evaluate potential projects or investments. Accountants advocate the use of the Simple Rate of Return, which is based

Chapter 11 Cash Flow Estimation and Risk Analysis ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS

Chapter 11 Cash Flow Estimation and Risk Analysis ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS 11-1 a. Cash flow, which is the relevant financial variable, represents the actual flow of cash. Accounting

Essential Learning for CTP Candidates TEXPO Conference 2016 Session #03

TEXPO Conference 2016: Essential Learning for CTP Candidates Session #3 (Mon.1:45 3:00 pm) Overview of Basic CTP Math from ETM4 Chap 07: Earnings Credits Chap 09: Working Capital Chap 18: Fin. Statements

CE Entrepreneurship. Investment decision making

CE Entrepreneurship Investment decision making Cash Flow For projects where there is a need to spend money to develop a product or establish a service which results in cash coming into the business in

Capital Budgeting Cash Flows

Learning Objectives 1-1 Capital Budgeting Cash Flows 1 Corporate Financial Management 3e Emery Finnerty Stowe 1-2 Calculate incremental after-tax cash flows for a capital budgeting project. Explain the

Vol. 2, Chapter 4 Capital Budgeting

Vol. 2, Chapter 4 Capital Budgeting Problem 1: Solution Answers found using Excel formulas: 1. Amount invested = \$10,000 \$21,589.25 Compounding period = annually Number of years = 10 Annual interest rate

What is the net present value of the project (to the nearest thousand dollars)?

corporate finance, final exam practice questions, NPV *Question 1.1: Net Present Value A firm invests \$200,000 in machinery that yields net after-tax cash flows of \$90,000 at the end of each of the next

2. (Ignore income taxes in this problem.) The following data pertain to an investment in equipment:

1. The net present value and internal rate of return methods of capital budgeting are superior to the payback method in that they: A) are easier to implement. B) consider the time value of money. C) require

Chapter 11 Investment Decision Criteria Chapter 11 Contents Learning Objectives Principles Used in This Chapter 1. An Overview of Capital Budgeting 2. Net Present Value 3. Other Investment Criteria 4.

Session #5 Capital Budgeting - II Damodaran - Chapter 9: 6,12,16,18 Chapter 10: 2,10,16(a&b) Chapter 11: 6,12,14

Session #5 Capital Budgeting - II Damodaran - Chapter 9: 6,12,16,18 Chapter 10: 2,10,16(a&b) Chapter 11: 6,12,14 I. Additional Issues in Capital Budgeting. A. Capital rationing: Use profitability index

EVALUATING CAPITAL INVESTMENTS IN AGRIBUSINESS Technological advancements impact the agribusiness industry in a very irregular fashion. Given the difficulties associated with predicting the arrival and/or

Chris Leung, Ph.D., CFA, FRM

FNE 215 Financial Planning Chris Leung, Ph.D., CFA, FRM Email: chleung@chuhai.edu.hk Chapter 2 Planning with Personal Financial Statements Chapter Objectives Explain how to create your personal cash flow

Strategy and Analysis in Using NPV. How Positive NPV Arises

Strategy and Analysis in Using NPV (Text reference: Chapter 8) Topics how positive NPV arises decision trees sensitivity analysis scenario analysis break-even analysis investment options AFM 271 - Strategy

\$1,300 + 1,500 + 1,900 = \$4,700. in cash flows. The project still needs to create another: \$5,500 4,700 = \$800

1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project has created: \$1,300 + 1,500 + 1,900 = \$4,700 in cash flows.

10.SHORT-TERM DECISIONS & CAPITAL INVESTMENT APPRAISAL

INDUSTRIAL UNIVERSITY OF HO CHI MINH CITY AUDITING ACCOUNTING FACULTY 10.SHORT-TERM DECISIONS & CAPITAL INVESTMENT APPRAISAL 4 Topic List INDUSTRIAL UNIVERSITY OF HO CHI MINH CITY AUDITING ACCOUNTING FACULTY

Chapter 10: Making Capital Investment Decisions

Chapter 10: Making Capital Investment Decisions Faculty of Business Administration Lakehead University Spring 2003 May 21, 2003 Outline 10.1 Project Cash Flows: A First Look 10.2 Incremental Cash Flows

Chapter 20 Lease Financing ANSWERS TO END-OF-CHAPTER QUESTIONS

Chapter 20 Lease Financing ANSWERS TO END-OF-CHAPTER QUESTIONS 20-1 a. The lessee is the party leasing the property. The party receiving the payments from the lease (that is, the owner of the property)

Financial and Cash Flow Analysis Methods. www.project-finance.com

Financial and Cash Flow Analysis Methods Financial analysis Historic analysis (BS, ratios, CF analysis, management strategy) Current position (environment, industry, products, management) Future (competitiveness,

Homework #3 BUSI 408 Summer II 2013

Homework #3 BUSI 408 Summer II 2013 This assignment is due 12 July 2013 at the beginning of class. Answer each question with numbers rounded to two decimal places. For relevant questions, identify the

Chapter 10 Capital Budgeting Techniques Copyright 2012 Pearson Prentice Hall. All rights reserved. Overview of Capital Budgeting Capital budgeting is the process of evaluating and selecting long-term investments

Course 3: Capital Budgeting Analysis

Excellence in Financial Management Course 3: Capital Budgeting Analysis Prepared by: Matt H. Evans, CPA, CMA, CFM This course provides a concise overview of capital budgeting analysis. This course is recommended

EXAM 1 REVIEW QUESTIONS

EXAM 1 REVIEW QUESTIONS 1) Free cash flow. Consider the following financial statements for United Technologies Corp. What is UT's free cash flow (total cash flow from assets) for 2001? UNITED TECHNOLOGIES:

CHAPTER 4 DISCOUNTED CASH FLOW VALUATION

CHAPTER 4 DISCOUNTED CASH FLOW VALUATION Solutions to Questions and Problems NOTE: All-end-of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability

Numbers 101: Taxes, Investment, and Depreciation

The Anderson School at UCLA POL 2000-20 Numbers 101: Taxes, Investment, and Depreciation Copyright 2002 by Richard P. Rumelt. In the Note on Cost and Value over Time (POL 2000-09), we introduced the basic

STATEMENT OF CASH FLOWS AND WORKING CAPITAL ANALYSIS

C H A P T E R 1 0 STATEMENT OF CASH FLOWS AND WORKING CAPITAL ANALYSIS I N T R O D U C T I O N Historically, profit-oriented businesses have used the accrual basis of accounting in which the income statement,

Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization

T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization! 9.1 Net Present Value! 9.2 The Payback Rule! 9.3 The Average Accounting Return! 9.4 The Internal Rate

CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS. 21-20 Capital budgeting with uneven cash flows, no income taxes.

CHAPTER 21 CAPITAL BUDGETING AND COST ANALYSIS 21-20 Capital budgeting with uneven cash flows, no income taxes. 1. Present value of savings in cash operating costs: \$10,000 0.862 \$ 8,620 8,000 0.743 5,944

Chapter 8. Capital Budgeting Cash Flows. Learning Goals. Learning Goals (cont.)

Chapter 8 Capital Budgeting Cash Flows Learning Goals 1. Understand the motives for key capital budgeting expenditures and the steps in the capital budgeting process. 2. Define basic capital budgeting

CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. Assuming conventional cash flows, a payback period less than the project s life means

Chapter 5 Revenue & Cost Analysis

Chapter 5 Revenue & Cost Analysis 1. General Cost data are subject to great misunderstanding than are value data. The main reason: although the various categories of costs have precise meaning to the accountant,

Chapter 010 Making Capital Investment Decisions

Multiple Choice Questions 1. The changes in a firm's future cash flows that are a direct consequence of accepting a project are called cash flows. A. incremental b. stand-alone c. after-tax d. net present

CHAPTER 8 INTEREST RATES AND BOND VALUATION

CHAPTER 8 INTEREST RATES AND BOND VALUATION Solutions to Questions and Problems 1. The price of a pure discount (zero coupon) bond is the present value of the par value. Remember, even though there are

Capital Budgeting Formula

apital Budgeting Formula Not in the book. Wei s summary If salvage value S is less than U n : If salvage value S is greater than U n : Note: IF t : incremental cash flows (could be negative) )(NW): change

Project Management Seminars. Financial Management of Projects

Project Management Seminars Financial Management of Projects.inproject managementandsystems engineering, is a deliverable-oriented decomposition of a project into smaller components. (source: Wikipedia)