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CMA Part 2

Financial Decision Making


SU 8.1 – The Capital Budgeting Process

• Capital budgeting is the process of planning


and controlling investment for long-term
projects.
– Will affect the company for many accounting
periods going forward
– Relatively inflexible once made

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SU 8.1 – The Capital Budgeting Process
– Predicting the need for future capital assets is one
of the more challenging tasks
• Affected by
– Inflation
– Interest rates
– Cash availability
– Market demands
– Production capacity is a key driver
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SU 8.1 – The Capital Budgeting Process

• Applications for capital budgeting


– Buying equipment
– Building facilities
– Acquiring a business
– Developing a product of product line
– Expanding into new markets

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SU 8.1 – The Capital Budgeting Process
• Important to correctly forecast future changes in
demand in order to have the correct capacity.
• Planning is crucial to anticipate changes in
capital markets, inflation, interest rates and
money supply.
• Consider the tax consequences.
– All decisions should be done on an after tax basis

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SU 8.1 – The Capital Budgeting Process
• Costs considered in capital budgeting
– Avoidable cost
• May be eliminated by ceasing or improving an activity.
– Common cost
• Shared by all options and is not clearly allocable.
– Deferrable cost
• May be shifted to the future.
– Fixed cost
• Does not very within relevant range.
– Imputed cost
• May not have a specific cash outlay in accounting
– Incremental cost continued
• Difference in cost of two options.
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SU 8.1 – The Capital Budgeting Process
– Opportunity cost
• Maximum benefit forgone based on next alternative, including that of the
stockholders (which also establishes the firms hurdle rate).
– Relevant cost
• Vary with action.
• Constant cost don’t affect decision.
– Sunk cost
• Cannot be avoided.
– Weighted-average Cost of Capital
• Weighted average of the interest cost of debt (net of tax) and the costs
(implicit or explicit) of the components of equity capital to be invested in long-
term assets. It is also the “hurdle rate”.

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SU 8.1 – The Capital Budgeting Process
• Stages in Capital Budgeting
1. Identification and definition
• Identify the strategy
• Define the projects
– Revenue, costs, and cash flow
– Most difficult stage
2. Search
• Each investment to be evaluated be each function
of the firms value chain.
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SU 8.1 – The Capital Budgeting Process
3. Information-acquisition
• Costs and benefits of the projects are enumerated
• Quantitative financial factors have highest priority
• Nonfinancial measures (quantitative and qualitative)
4. Selection
• Increase shareholder value. NPV, IRR..
5. Financing
• Debt or equity
6. Implementation and monitoring
• Feedback and reporting
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SU 8.1 – The Capital Budgeting Process
• Investment Ranking Steps
– Determine Net Investment Costs
• Gross cash requirement less cash recovered from trade or sale of existing
assets, adjusted for taxes
• Investment required includes funds to provide for increases in working capital,
i.e. additional receivables and inventories.
– Calculating estimated cash flows
• Capture increase in revenue, decrease costs
• Net cash-flow period by period from investment
• Economic life of the investment
• Depreciable life
– Comparing cash-flows to Net Investment Costs
• Evaluate the benefit
– Ranking investments
• NPV, IRR, Payback 10
SU 8.1 – The Capital Budgeting Process
• Book Rate of Return =
GAAP NI from Investment
Book Value of Investment
– Also called accrual accounting rate of return
– Don’t use accrual accounting numbers, instead use cash flow
• Net Income is affected by company’s choices of accounting methods
– Also, do not compare project book rate to company’s book rate
of return for investments which could be distorted

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SU 8.1 – The Capital Budgeting Process
• Relevant Cash Flows
– Net initial investment
• New equipment cost
• Working capital requirements,
• After tax disposals proceeds
– Annual net cash flows
• After tax cash collections for operations
• Depreciation tax savings
– Project termination cash flows
• After tax disposal
• Working capital recovery

Ø See example on page 309


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SU 8.1 – The Capital Budgeting Process
• Other Considerations
– Inflation
• Raises hurdle rate
– Post-audits – Deterrent of bad projects.
• Actual to expected cash flow
• Identify sources of unrealistic estimates
• Avoid premature evaluations of projects
• Non-quantitative benefits
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SU 8.1 – The Capital Budgeting Process Practice
Question 1
The relevance of a particular cost to a decision is determined by

A Riskiness of the decision.

B Number of decision variables.

C Amount of the cost.

D Potential effect on the decision.

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SU 8.1 – The Capital Budgeting Process Practice
Question 1 Answer
Correct Answer: D
Relevance is the capacity of information to make a difference in a decision by
helping users of that information to predict the outcomes of events or to
confirm or correct prior expectations. Thus, relevant costs are those expected
future costs that vary with the action taken. All other costs are constant and
therefore have no effect on the decision.

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SU 8.1 – The Capital Budgeting Process Practice
Question 2
Lawson, Inc., is expanding its manufacturing plant, which requires an investment of
$4 million in new equipment and plant modifications. Lawson’s sales are expected to
increase by $3 million per year as a result of the expansion. Cash investment in
current assets averages 30% of sales; accounts payable and other current liabilities
are 10% of sales. What is the estimated total investment for this expansion?
A $3.4 million.

B $4.3 million.

C $4.6 million.

D $5.2 million.

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SU 8.1 – The Capital Budgeting Process Practice
Question 2 Answer
Correct Answer: C
The investment required includes increases in working capital (e.g., additional
receivables and inventories resulting from the acquisition of a new
manufacturing plant). The additional working capital is an initial cost of the
investment, but one that will be recovered (i.e., it has a salvage value equal to
its initial cost). Lawson can use current liabilities to fund assets to the extent
of 10% of sales. Thus, the total initial cash outlay will be $4.6 million {$4
million + [(30% – 10%) × $3 million sales]}.

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SU 8.1 – The Capital Budgeting Process Practice
Question 3
What is the net cash outflow at the beginning of the first year that
Dickins should use in a capital budgeting analysis?

A $(170,000)

B $(180,000)

C $(192,000)

D $(210,000)

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SU 8.1 – The Capital Budgeting Process Practice
Question 3 Answer
Correct Answer: D
Delivery and installation costs are essential to preparing the machine for its
intended use. Thus, the company must initially pay $210,000 for the machine,
consisting of the invoice price of $180,000, the delivery costs of $12,000, and
the $18,000 of installation costs.

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SU 8.2 – Risk Analysis and Real Options
In Capital Investments
• Risk analysis – Attempt to measure the variability of future returns from
proposed investment.
– Informal method – NPV is calculated and reviewed.
– Risk-adjusted discount rates – Adjust rate of return upwards as project
becomes more risky.
– Certainty equivalent adjustments- from Utility theory – the point where you
are indifferent to a choice between a certain sum of money and the expected
value of a risky sum.
– Simulation analysis – Computer is used to generate many results based upon
various assumptions.
• Pilot plants
– Sensitivity analysis – An iterative process of recalculated returns based on
changing assumptions.
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SU 8.2 – Risk Analysis and Real Options
In Capital Investments
• Real (managerial or strategic) options
– Value of a real option – The difference between the projects NPV with
the option vs. without the option.
• Usually more valuable the later it is exercised.
– Types of real options:
• Abandonment (Put option)
• Follow-up investment
• Wait and Learn (call option)
• Flexibility option – vary an input
• Capacity option – vary an output
• New geographical markets
• New product option – follow on products

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SU 8.2 – Risk Analysis and Real Options
In Capital Investments Question 1
Sensitivity analysis, if used with capital projects,
A Is used extensively when cash flows are known with certainty.
Measures the change in the discounted cash flows when using the
B discounted payback method rather than the net present value
method.

Is a “what-if” technique that asks how a given outcome will change if


C
the original estimates of the capital budgeting model are changed.

D Is a technique used to rank capital expenditure requests.

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SU 8.2 – Risk Analysis and Real Options
In Capital Investments Question 1 Answer
Correct Answer: C
After a problem has been formulated into any mathematical model, it may be
subjected to sensitivity analysis, which is a trial-and-error method used to
determine the sensitivity of the estimates used. For example, forecasts of
many calculated NPVs under various assumptions may be compared to
determine how sensitive the NPV is to changing conditions. Changing the
assumptions about a certain variable or group of variables may drastically
alter the NPV, suggesting that the risk of the investment may be excessive.

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SU 8.2 – Risk Analysis and Real Options
In Capital Investments Question 2
When the risks of the individual components of a project’s cash flows are
different, an acceptable procedure to evaluate these cash flows is to
A Divide each cash flow by the payback period.

Compute the net present value of each cash flow using the firm’s cost of
B
capital.

C Compare the internal rate of return from each cash flow to its risk.

Discount each cash flow using a discount rate that reflects the degree of
D
risk.

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SU 8.2 – Risk Analysis and Real Options
In Capital Investments Question 2 Answer
Correct Answer: D
Risk-adjusted discount rates can be used to evaluate capital investment
options. If risks differ among various elements of the cash flows, then
different discount rates can be used for different flows.

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SU 8.2 – Risk Analysis and Real Options
In Capital Investments Question 3
Sensitivity analysis is used in capital budgeting to
A Estimate a project’s internal rate of return.
Determine the amount that a variable can change without generating
B
unacceptable results.
C Simulate probabilistic customer reactions to a new product.
Identify the required market share to make a new product viable and
D
produce acceptable results.

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SU 8.2 – Risk Analysis and Real Options
In Capital Investments Question 3 Answer
Correct Answer: B
After a problem has been formulated into any mathematical model, it may be
subjected to sensitivity analysis, which is a trial-and-error method used to
determine the sensitivity of the estimates used. For example, forecasts of
many calculated NPVs under various assumptions may be compared to
determine how sensitive the NPV is to changing conditions. Changing the
assumptions about a certain variable or group of variables may drastically
alter the NPV, suggesting that the risk of the investment may be excessive.

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SU 8.3 – Discounted Cash Flow Analysis
• Time Value of Money
– Concept: A dollar received in the future is worth less than today.
– Present Value (PV) – Value today of future payment
– Future Value (FV) – Future value of an investment today.
– Annuities – equal payments at equal intervals
• Ordinary annuity (in arrears)
• Annuity due (in advance) – PV & FV is always greater than ordinary
annuity

Ø See examples on page 310 through 312

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SU 8.3 – Discounted Cash Flow Analysis
– Hurdle rate
• Goal is for companies discount rate to be as low as
possible.
• WACC or Shareholder’s opportunity cost of capital.
• The lower the firm’s discount rate, the lower the
“hurdle” the company must clear to achieve
profitability

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SU 8.3 – Discounted Cash Flow Analysis

• Net Present Value (NPV)


– Project return in $$
– Positive NPV indicates a higher rate of return than
the company’s desired rate

Ø See example on 313

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SU 8.3 – Discounted Cash Flow Analysis

• Internal Rate of Return (IRR)


– Project return in %
– IRR shortcomings -
• Directional changes of cash flows
• Mutually exclusive projects
• Varying rates of return
• Multiple investments
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SU 8.3 – Discounted Cash Flow Analysis

• Cash flows and discounting


NPV = Cash flow0 + Cash flow1 + Cash flow2
(1 + r)0 (1 + r)1 (1 + r)2

ØComparing Cash Flow Patterns – Page 315

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SU 8.3 – Discounted Cash Flow Analysis
• NPV vs IRR comparison
– Reinvestment rate NPV assumes the cash flow can be reinvested at projects
discount rate.
– Independent projects:
• NPV and IRR give same accept/reject decision if projects are independent.
• All acceptable independent projects can be undertaken.
– Mutually exclusive projects.
• Cost of one greater than other
• Timing, amounts, and direction of cash flow are different
• Different useful lives
• IRR provides 1 rate, NPV can be used with multiple rates.
• Multiple investments. NPV is adaptable, IRR is not.
• IRR assumes cash flow is reinvested at IRR rate.
• NPV assumes reinvestment in the desired rate of return.
– NPV and IRR are most sound decision making tools for wealth maximization.
Ø NPV profile – Page 317
• Select greatest NPV over greatest IRR 33
SU 8.3 – Discounted Cash Flow Analysis
Question 1
The net present value (NPV) method of investment project analysis assumes
that the project’s cash flows are reinvested at the
A Computed internal rate of return.

B Risk-free interest rate.

C Discount rate used in the NPV calculation.

D Firm’s accounting rate of return.

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SU 8.3 – Discounted Cash Flow Analysis
Question 1 Answer
Correct Answer: C
The NPV method is used when the discount rate is specified. It assumes that
cash flows from the investment can be reinvested at the particular project’s
discount rate.

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SU 8.3 – Discounted Cash Flow Analysis
Question 2
The net present value of a proposed investment is negative; therefore, the
discount rate used must be
A Greater than the project’s internal rate of return.
B Less than the project’s internal rate of return.
C Greater than the firm’s cost of equity.
D Less than the risk-free rate.

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SU 8.3 – Discounted Cash Flow Analysis
Question 2 Answer
Correct Answer: A
The higher the discount rate, the lower the NPV. The IRR is the discount rate
at which the NPV is zero. Consequently, if the NPV is negative, the discount
rate used must exceed the IRR.

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SU 8.3 – Discounted Cash Flow Analysis
Question 3
Dr. G invested $10,000 in a lifetime annuity for his granddaughter Emily. The
annuity is expected to yield $400 annually forever. What is the anticipated
internal rate of return for the annuity?
A Cannot be determined without additional information.
B 4.0%
C 2.5%
D 8.0%

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SU 8.3 – Discounted Cash Flow Analysis
Question 3 Answer
Correct Answer: B
The correct answer is 4.0%.
$10,000 = $400 ÷ IRR; IRR = 0.040 = 4.0%.

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SU 8.4 – Payback and Discounted Payback
• Payback period is the number of years it take
for an asset to pay for itself
– Pro
• Simple
– Cons
• No consideration for time value of money
• Does not consider cash flow after payback period

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SU 8.4 – Payback and Discounted Payback

• Constant cash flows


Initial net investment
Payback =
Annual expected cash flow
• Variable cash flows
– Cumulative calculation

ØSee example on page 318


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SU 8.4 – Payback and Discounted Payback
• Discounted payback method
– Used to overcome the payback methods disregard for
time value of money
– Pro
• More conservative yet still simple
– Con
• Does not consider cash flow after payback period.

Ø See example
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SU 8.4 – Payback and Discounted Payback
• Other payback methods
– Bailout payback
• Considers salvage value
– Payback reciprocal
• 1 / payback
• Estimate of IRR
continued

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SU 8.4 – Payback and Discounted Payback
– Breakeven time
• Time require for discounted cash flows to equal 0
• Alternative is to consider the time required for the
present value of the cumulative cash inflows to equal
the present value of all the expected future cash flows

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SU 8.4 – Payback and Discounted Payback
Question 1
Which one of the following methods for evaluating capital projects is the
least useful from an investment analysis point of view?

A Accounting rate of return.

B Internal rate of return.

C Net present value.

D Payback.

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SU 8.4 – Payback and Discounted Payback
Question 1 Answer
Correct Answer: A
The accounting, or book, rate of return is an unsatisfactory means of
evaluating capital projects for two major reasons. Because the accounting
rate of return uses accrual-basis numbers, the calculation is subject to such
accounting judgments as how quickly to depreciate capitalized assets. Also,
the accounting rate of return is an average of all of a firm’s capital projects; it
reveals nothing about the performance of individual investment choices.

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SU 8.4 – Payback and Discounted Payback
Question 2
The payback reciprocal can be used to approximate a project’s
A Profitability index.

B Net present value.

C Accounting rate of return if the cash flow pattern is relatively stable.

D Internal rate of return if the cash flow pattern is relatively stable.

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SU 8.4 – Payback and Discounted Payback
Question 2 Answer
Correct Answer: D
The payback reciprocal (1 ÷ payback) has been shown to approximate the
internal rate of return (IRR) when the periodic cash flows are equal and the
life of the project is at least twice the payback period.

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SU 8.5 – Ranking Investment Projects

• Why should we rank investment projects?


– Capital rationing
• Reasons
– Lack of financial resources
– Control estimation bias
– Unwillingness to issue new equity (to raise new capital)

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SU 8.5 – Ranking Investment Projects
• Methods
– Profitability index =
NPV
Net Investment
Ø See example
– Internal capital markets – Internal funding
– Linear programming – Technique for optimizing
resource allocation.
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SU 8.5 – Ranking Investment
Projects Question 1
The profitability index approach to investment analysis
A Fails to consider the timing of project cash flows.

Considers only the project’s contribution to net income and does not
B
consider cash flow effects.

Always yields the same accept/reject decisions for independent projects


C
as the net present value method.

Always yields the same accept/reject decisions for mutually exclusive


D
projects as the net present value method.

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SU 8.5 – Ranking Investment Projects Question
1 Answer
Correct Answer: C
The profitability index (excess present value index) of an investment is the
ratio of the present value of the future net cash flows (or only cash inflows) to
the net initial investment. It is a variation of the net present value (NPV)
method and facilitates the comparison of different-sized investments.
Because it is based on the NPV method, the profitability index will yield the
same decision as the NPV for independent projects. However, decisions may
differ for mutually exclusive projects of different sizes.

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SU 8.5 – Ranking Investment Projects
Question 2
The method that divides a project’s annual after-tax net income by the
average investment cost to measure the estimated performance of a capital
investment is the
A Internal rate of return method.

B Accounting rate of return method.

C Payback method.

D Net present value (NPV) method.

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SU 8.5 – Ranking Investment Projects
Question 2 Answer
Correct Answer: B
The accounting rate of return uses undiscounted net income (not cash flows)
to determine a rate of profitability. Annual after-tax net income is divided by
the average carrying amount (or the initial value) of the investment in assets.

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SU 8.5 – Ranking Investment Projects
Question 3
The technique that measures the estimated performance of a capital
investment by dividing the project’s annual after-tax net income by the
average investment cost is called the
A Bail-out payback method.
B Internal rate of return method.
C Profitability index method.
D Accounting rate of return method.

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SU 8.5 – Ranking Investment Projects
Question 3 Answer
Correct Answer: D
The accounting rate of return (also called the unadjusted rate of return or
book value rate of return) measures investment performance by dividing the
accounting net income by the average investment in the project. This method
ignores the time value of money.

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SU 8.6 – Comprehensive Examples

ØPlease study the comprehensive page starting


on page 253

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