Corporate finance: Capital Budgeting

What is capital budgeting?

• •A set of rules and regulations defining how companies are managed

  •A framework delineating the roles responsibilities and rights of a company´s stakeholders.

• Firms Provides assurance that companies present their financial information in a firm and accurate way.

• An investment assessment method is applied for large and risky investments such as Fixed assets or long-term Projects. The investment decision is irreversible (potential sunk cost) and it’s likely to impact the business in the long run. The method helps to compare options by using an extensive capital investment analysis

• When an agent is hired by a principal to perform a certain task, to safeguard principal´s interest in the best possible way.

Principles of Capital Budgeting

Pick the affirmations that are correct

• Decisions are based on accounting income , not on cash flows

• Cash flows revolve around the concept of opportunity cost

• Positive cash flows are better later rather than sooner because of the time value of money

• Cash Flow is analyzed on an Before-tax basis

• Financing costs are reflected in a Project´s required rate of return.

Independent vs Mutually exclusive

Pick the affirmations that are correct

• Independent projects:
  Must be evaluated as standalone initiatives

• Independent projects:
  If both are profitable, I could realize them simultaneously
  I

• Mutually exclusive projects:
  If both are profitable, I cannot realize them simultaneously

• In mutually exclusive projects I must choose one

• In independent projects I must choose one

NPV

• It measures a project´s investment attractiveness. Is calculated by dividing the present value of future expected cash flows by the initial investment.

• It uses accounting measures

  Commonly used when considering multiple projects as it provides the return of each project.

  It doesn’t differentiate between investments that yield different cash flow over time and the time value of money
  (Average Net Income)/(Average book value)

• It is defined as the discount rate that makes the NPV equal to zero, it is a single discount rate that summarizes the merits of a project. It doesn’t depend on market interest rates but rather on the implicit cash flow of the project.

• The amount of time it takes to pay back an initial investment, in other words how long it takes an investment to reach a breakeven point.

• Is the difference between the present value of cash inflows and the present value of cash outflows over some time being a measure of how much value we create when undertaking an investment.

IRR

• It measures a project´s investment attractiveness. Is calculated by dividing the present value of future expected cash flows by the initial investment.

• It uses accounting measures

  Commonly used when considering multiple projects as it provides the return of each project.

  It doesn’t differentiate between investments that yield different cash flow over time and the time value of money
  (Average Net Income)/(Average book value)

• It is defined as the discount rate that makes the NPV equal to zero, it is a single discount rate that summarizes the merits of a project. It doesn’t depend on market interest rates but rather on the implicit cash flow of the project.

• The amount of time it takes to pay back an initial investment, in other words how long it takes an investment to reach a breakeven point.

• Is the difference between the present value of cash inflows and the present value of cash outflows over some time being a measure of how much value we create when undertaking an investment.

PAYBACK PERIOD

• It measures a project´s investment attractiveness. Is calculated by dividing the present value of future expected cash flows by the initial investment.

• It uses accounting measures

  Commonly used when considering multiple projects as it provides the return of each project.

  It doesn’t differentiate between investments that yield different cash flow over time and the time value of money
  (Average Net Income)/(Average book value)

• It is defined as the discount rate that makes the NPV equal to zero, it is a single discount rate that summarizes the merits of a project. It doesn’t depend on market interest rates but rather on the implicit cash flow of the project.

• The amount of time it takes to pay back an initial investment, in other words how long it takes an investment to reach a breakeven point.

• Is the difference between the present value of cash inflows and the present value of cash outflows over some time being a measure of how much value we create when undertaking an investment.

AVERAGE ACCOUNTING RATE OF RETURN

• It measures a project´s investment attractiveness. Is calculated by dividing the present value of future expected cash flows by the initial investment.

• It uses accounting measures

  Commonly used when considering multiple projects as it provides the return of each project.

  It doesn’t differentiate between investments that yield different cash flow over time and the time value of money
  (Average Net Income)/(Average book value)

• It is defined as the discount rate that makes the NPV equal to zero, it is a single discount rate that summarizes the merits of a project. It doesn’t depend on market interest rates but rather on the implicit cash flow of the project.

• The amount of time it takes to pay back an initial investment, in other words how long it takes an investment to reach a breakeven point.

• Is the difference between the present value of cash inflows and the present value of cash outflows over some time being a measure of how much value we create when undertaking an investment.

PROFITABILITY INDEX

• It measures a project´s investment attractiveness. Is calculated by dividing the present value of future expected cash flows by the initial investment.

• It uses accounting measures

  Commonly used when considering multiple projects as it provides the return of each project.

  It doesn’t differentiate between investments that yield different cash flow over time and the time value of money
  (Average Net Income)/(Average book value)

• It is defined as the discount rate that makes the NPV equal to zero, it is a single discount rate that summarizes the merits of a project. It doesn’t depend on market interest rates but rather on the implicit cash flow of the project.

• The amount of time it takes to pay back an initial investment, in other words how long it takes an investment to reach a breakeven point.

• Is the difference between the present value of cash inflows and the present value of cash outflows over some time being a measure of how much value we create when undertaking an investment.

Initial Outlay 135.000
3 year cashflow of 45.000
market rate = 12%
NPV?

• NPV = 27.190,6
  
  Invest

• NPV = - 27.190,6
  
  Invest

• NPV = 0
  Indifferent

• NPV = -26.918
  
  Invest

• NPV = -26.918
  
  Do not Invest

Initial Outlay 135.000
3 year cashflow of 45.000
market rate = 12%
IRR?

• IRR = 12%
  
  Invest

• IRR = 12%
  
  Do not Invest

• IRR = 8%
  
  Do not Invest

• IRR = 0%
  
  Do not Invest

• IRR = 0%
  
  Invest