4. Capital Budgeting

9. Net Present Value and Other Investment Criteria

• NPV = - initial cost + present value
  • NPV Rule: NPV>0, do invest

• Payback Rule
  • payback: length of time it takes recover our initial investment (break-even measure)
  • Discounted payback:  length of time required for an investment's discounted cash flows to equal its initial cost

• AAR: Average accounting return
  • = average net income / average book value ... (similar to ROA)

• IRR: Internal Rate of Return
  •  the discount rate that makes NPV of an investment zero
  • IRR can be multiple, not only one

 

• PI: Profitability Index (benefit-cost ratio)
  •  present value of an investment's future cash flows divided by its initial cost
  • if NPV is positive, PI > 1, but NPV is negative, PI < 1
    • ex) PI = 1.1 means per dollar invested, 1.10 dollar in value or 0.10 dollar in NPV results

 

 

10. Making Capital Investment Decisions

• The identification of relevant project cash flows
  • how to handle some issues that often come up, including sunk costs, opportunity costs, financing costs, net working capital, and erosion
• Preparing and using pro forma, or projected, financial statements
  •  some alternative definitions of operating cash flow
• The role of net working capital and depreciation in determining project cash flows
  • including the change in net working capital was important in cash flow analysis, because it adjusted for the discrepancy(불일치) between accounting revenues an costs and cash revenues and costs
  • calculation of depreciation expense under current tax law
• Some special cases encountered in using discounted cash flow analysis
  • evaluating cost-cutting investments
  • how to go about setting a bid price
  • the unequal lives problem

11. Project Analysis and Evaluation

The most important thing to carry away from this chapter is that estimated NPVs or returns should not be taken at face value. They depend critically on projected cash flows.

• Net present value estimates depend on projected future cash flows 
  • ecasting risk: If there are errors in those projections, then our estimated NPVs can be misleading 
• Scenario and sensitivity analysis are useful tools for identifying which variables are critical to the success of a project and where forecasting problems can do the most damage
  • Scenario: What happens to NPV estimates when we ask what-if question?
    
    • Best Case, Base Case, Worst Case
  • Sensitivity: What happens to NPV when only one variable is changed?
    • NPV up, NPV 그대로, NPV down 
• Break-even analysis in its various forms is a particularly common type of scenario analysis that is useful for identifying critical levels of sales
  • Calculate payback period
  • Project Net Income = (Sales - Variable costs - Fixed cost - Depreciation) X (1 - T)
  • Break even point is at "Net income=0"

• Operating Cash Flow (OCF)

• Operating leverage is a key determinant of break-even levels
  • It reflects the degree to which a project or a firm is committed to fixed costs
  • The degree of operating leverage tells us the sensitivity of operating cash flow to changes in sales volume
• Projects usually have future managerial options associated with them. 
  • These options may be very important, but standard discounted cash flow analysis tends to ignore them
• Capital rationing occurs when apparently profitable projects cannot be funded
  • Standard discounted cash flow analysis is troublesome in this case, because NPV is not necessarily the appropriate criterion anymore
  • Soft rationing: when units in a business are allocated a certain amount of financing for captial budgeting
  • Hard rationing: when a business cannot raise financing for a project under any circumstances