The cash cost of additional resources, such as wages for hiring more workers, or expenses for supplies, [should / should not] be considered when calculating the effects of a new project on working capital.
Cash will be needed to pay for the extra expenses and their effects should be considered at the inception of a project.
When considering cash flows -- a previous asset is sold and replaced by a new asset, how do the proceeds, gain, or loss of this disposal affect the new project?
If the replaced asset is abandoned: the net salvage value is treated as a reduction of the initial investment in the new asset. Any remaining book value should not be considered in the decision-making process (sunk cost), but can be used as a tax loss.
If the replaced asset is sold: The cash received reduces the new investment's value. Any gain/loss is used for tax purposes and may pose an additional change to the initial investment [tax paid on a gain reduces sales price received, tax saved on a loss increases sales price received]
What are the 3 stages of cash flows during the life cycle of a capital investment project?
(1) inception of the project (time period zero) = acquisition cost of the asset, addl cash costs for the project (wages, supplies), effects of sale/abandonment of previous asset
(2) Operations = future annual cash inflows and outflows (net) including depreciation tax shields
(3) Disposal of the Project = one time cash inflow during the terminal year
Which is the preferred method decision-makers use to determine whether or not to invest in a capital asset?
Net Present Value (NPV) Method
Using the Net Present Value (NPV) method, what are the effects of a higher hurdle rate, and when would a higher hurdle rate be expected?
A higher hurdle rate makes it more difficult to achieve a (+) NPV and thus accept a new project
A higher hurdle rate is expected for a higher risk project or when the company itself is considered high risk.
What are the steps used to calculate the Net Present Value (NPV) amount? Decisions are based on which outcomes?
(1) Calculate the after-tax net cash flows [cash flows x (1-tax rate)]
(2) Add the after-tax depreciation benefit [depreciation expense x tax rate]
(3) Calculate the yearly present value (PV) of these cash flows
(4) Subtract the initial cash outflow
If the NPV is (+), accept the project; if (-), reject the project.
True / False: The NPV method can only use the WACC as the hurdle rate, and the rate must be constant throughout the project.
Any hurdle rate (WACC, DCF, IRR, etc) may be used and adjusted during various periods.
What are the advantages and limitations of the Net Present Value (NPV) method?
Advantages: flexible; can be used with various cash flows and hurdle rates
Limitations: doesn't provide a true rate of return, it merely indicates whether this project can best a hurdle rate
When capital is limited, what method is used to determine which project(s) should be attempted?
Either the (1) maximum net present value, or
(2) Profitability Index = PV of net future cash inflow / PV of net initial investment, and then select the projects with the highest Index to the lowest until the amt of available capital is expended.
What is the Internal Rate of Return (IRR) formula. When would a project be accepted / rejected? What is another name for IRR?
aka Time-Adjusted Rate of Return
Net incremental investment / net annual cash flows
Accept when IRR > Hurdle rate; otherwise reject.
What are the limitations of IRR?
(1) Unreasonable reinvestment assumption = if IRR is unreasonably high/low, reinvestment at these levels isn't possible
(2) Inflexible cash flow assumption = can't be accurately calculated when cash flows fluctuate period-to-period
(3) IRR ignores the size (total amount invested or total amount of return) of the investment.
Ex #3: You calculate an IRR of 3% for one project, 13% for another. The 13% return seems best. But the 13% return is on a maximum investment of $10, while the 3% return is on a max investment of $1M.
What is the purpose of the Payback Period Method?
The period of time to recoup the initial investment. Used by companies that experience rapid technological changes and they want to recoup their investment quickly before their products become obsolete.
What are the advantages and disadvantages of the Payback Period Method?
Advantages: easy to use and understand, emphasis is on liquidity (return of principal)
Limitations: the time value of money is ignored, returns after the payback period is met are ignored (ignores profit), reinvestment of cash flows is ignored.
How is the Discount Payback Method used? What is another name for this method?
aka Breakeven Time Method
Uses the PV of each period's cash flows
Determines how quickly the initial investment is recovered and then we will make a profit.