Information about Capital Budgeting: Ranking Investment Proposals, Estimating Cash Flows

Methods of Ranking Investment Proposals

Estimating Cash Flows

Resources:

fppt.com

idc-online.com/technical_references/pdfs/project.../fm10.pdf

en.wikipedia.org/wiki/Net_present_value

faculty.philau.edu/MalhotraD/642Cash%20Flow%20Estimation.ppt

Estimating Cash Flows

Resources:

fppt.com

idc-online.com/technical_references/pdfs/project.../fm10.pdf

en.wikipedia.org/wiki/Net_present_value

faculty.philau.edu/MalhotraD/642Cash%20Flow%20Estimation.ppt

Methods of Ranking Investment Proposals • Payback Period – number of years (or time period) required to return the original investment.* • Net Present Value (NPV) - the “difference amount” between the sums of discounted: cash inflows and cash outflows. It compares the present value of money today to the present value of money in the future, taking inflation and returns into account.** • Internal Rate of Return - The discount rate found by trial and error which makes NPV = 0*

Payback Period Method • Assume that two projects are being considered by a company. Each requires a capital investment of $10,000. The marginal cost of capital is 10%. The net cash flows (i.e. net operating incomes after taxes plus the depreciation allowance) from the investments A and B are shown in the following table. View slide

Payback Period Method • Assume that two projects are being considered by a company. Each requires a capital investment of $10,000. The marginal cost of capital is 10%. The net cash flows (i.e. net operating incomes after taxes plus the depreciation allowance) from the investments A and B are shown in the following table. 2 YEAR PAYBACK! 4 YEAR PAYBACK! View slide

Payback Period Method • Which is more desirable? • Are they both the same?

Payback Period Method • Disadvantage: taking into account time value of money. Money received in the future is worth less than a money received today!

Net Present Value Technique 1. NPV uses cash flows. 2. NPV uses all the cash flows of the project. 3. NPV discounts the cash flows properly.

Net Present Value Technique 1. NPV uses cash flows. 2. NPV uses all the cash flows of the project. 3. NPV discounts the cash flows properly.

Net Present Value Technique

Internal Rate of Return (IRR) Method • The IRR is about as close as you can get to the NPV without actually being the NPV. • Provides a single number summarizing the merits of a project.

ESTIMATING PROJECT CASH FLOWS BEFORE PROCEEDING… • A FIRM is any business whether a proprietary, partnership or corporation. • TECHNIQUES IN CORPORATE FINANCE generally use CASH FLOWS. • NPV discounts CASH FLOWS, NOT EARNINGS. SINGLE PROJECT • Discount the cash flows that the firm receives from the project VALUING THE FIRM • Discount dividends –not earnings. • Dividends are the cash flows an investor receives.

CASH FLOW! To use the methods we learned from ranking investment proposals for capital budgeting analysis successfully and accurately, we must be: unbiased in estimating the expected future cash flows of the project. Assess the time of completion and estimate initial investment / cost

CASH FLOW! PROJECT IS A SUCCESS! Correct estimation of Cash flows. IT DOESN’T MATTER! Which technique used if the cash flow estimates is incorrect.

RELEVANT VS. IRRELEVANT CASH FLOWS The results of an acceptance of a project is to change the cash flows of a firm. Cash flows of a firm that change because of the project are called “relevant” cash flows; Any cash flows that does not change irrespective of the acceptance/rejection of the project is “irrelevant” to decision making and should not be considered.

POINTS TO CONSIDER • A cost that has already been incurred and thus cannot be recovered. • R&D, Market Research, Consultant’s Fees SUNK COST • The cash flow foregone by using your resources in a particular way. • Resources that have multiple uses. OPPORTUNITY COST • Erosion occurs when a new product reduces sales = cash flow reduction on existing products. • Synergy increases the cash flow of existing projects. SIDE EFFECTS • Viewed as a cash outflow of a project if it is an incremental cost of ALLOCATED the project. COSTS • Net working capital is defined as current assets minus current liabilities. • As a cash outflow and inflow. NET WORKING CAPITAL

DISCOUNTING: NOMINAL OR REAL? • Refers to the actual dollars to be received or (paid out) • Must be discounted at the nominal rate. NOMINAL CASH FLOW • Refers to the cash flow’s purchasing power. • Must be discounted at the real rate. REAL CASH FLOW

DISCOUNTING: NOMINAL OR REAL? NOMINAL DISCOUNTING REAL DISCOUNTING •The NPV is the same whether cash flows are expressed in nominal or in real quantities.

SAMPLE EXERCISE: •The NPV is the same whether cash flows are expressed in nominal or in real quantities.

NOMINAL APPROACH

REAL APPROACH

ALTERNATIVE APPROACHES OPERATING CASH FLOW (OCF) GIVEN Top-Down Approach Bottom-Up Approach Tax Shield Approach

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Capital budgeting is ... the effect of inflation has not been considered on the appraisal of capital investment proposals. ... Capital budgeting Cash flow

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Title: Chapter 10: Capital Budgeting: Cash Flow Principles Author: William Yacovissi Last modified by: William Yacovissi Created Date: 11/27/2002 7:51:00 PM

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