978-1111971724 Kinney 9e IM Ch 15 Lecture Note Part 2

Chapter 15: Capital Budgeting IM 11

publicly accessible website, in whole or in part.

ii. Although depreciation is not a cash flow, it has cash flow implications because of its

effect on income tax payments.

purposes.

purposes multiplied by the tax rate.

3. Alternative depreciation methods and asset depreciable lives for tax purposes can dramatically

affect projected after-tax cash flows, NPV, PI, and IRR.

that result if the same project is subjected to either a 25 percent (situation B) or 40 percent

(situation C) tax rate.

4. Managers are best able to make informed decisions concerning capital investments if they

understand how depreciation and taxes affect the various capital budgeting techniques.

LO.6: What are the underlying assumptions and limitations of each capital project evaluation

method?

G. Assumptions and Limitations of Methods

budgeting models.

use several techniques to evaluate a project.

3. All of the methods have two similar limitations:

investment recovery; and

b. All of the methods use single, deterministic measures of cash flow amounts rather than

probabilities.

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4. The first limitation can be compensated for by subjectively favoring projects whose cash flow

H. Investment Decision

1. Management must identify the best asset(s) for the firm to acquire to fulfill the company’s goals

and objectives. Making such an identification requires answering the following four questions.

a. Is the activity worthy of an investment?

i. A company acquires assets when they have value in relation to specific activities in which

the company is engaged.

ii. An activity’s worth is measured by cost-benefit analysis, and for most capital budgeting

iii. Difficulty in quantification is no reason to exclude benefits from capital budgeting

iv. Monetary benefits of the capital project may be known in advance not to exceed the

b. Which assets can be used for the activity?

i. The determination of available and suitable assets to conduct the intended activity is

ii. Management must have an idea of how much the needed assets will cost to determine if

to answer the next question.

c. Of the available assets for each activity, which is the best investment?

i. Management should select the best asset from the possible candidates and exclude all

others from consideration, using all available information.

ii. If a company has a standing committee to discuss, evaluate, and approve capital

made—screening and preference decisions.

 A screening decision is the first decision made in evaluating capital projects that

 A preference decision is the second decision made in capital project evaluation in

objectives.

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iii. Deciding which asset is the best investment requires the use of one or more of the

invest?

i. Mutually exclusive projects are composed of a set of proposed capital projects that

another.

iii. Mutually inclusive projects are composed of a set of capital projects that are all related

and that must all be chosen if the primary project is chosen.

iv. Text Exhibit 15.9 (p. 616) illustrates a typical investment decision process in which a firm

is determining the best way to provide transportation for its sales force.

efficient use of resources.

 The evaluation process should consider activity priorities, cash flows, and project

risk.

 Projects should then be ranked in order of acceptability.

LO.7: How do managers rank investment projects?

I. Ranking Multiple Capital Projects

1. All time-value-of-money evaluation techniques will typically indicate the same decision alternative.

2. Often managers must choose among multiple, mutually exclusive projects.

a. Multiple project evaluation decisions require that a ranking be made, generally using net

b. Managers can use results from the evaluation techniques to rank projects in descending

the NPV or PI methods.

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publicly accessible website, in whole or in part.

e. Conflicting results arise because of differing underlying reinvestment assumptions among

the three methods.

such a case, the IRR method could provide a misleading indication of project success

because additional projects that have such a high return might not be found.

LO.8: How is risk considered in capital budgeting analyses?

returns from an investment.

a. Managers considering a capital investment should understand and compensate for the

b. A manager may use the following three approaches to compensate for risk: the judgmental

2. Judgmental Method

3. Risk-Adjusted Discount Rate Method

inflows (outflows) to compensate for increased risk.

b. Text Exhibit 15.10 (p. 618) provides estimates of the development cost, annual cash

for risk.

4. Sensitivity Analysis

a. General

originally expected.

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b. Range of the Discount Rate

i. A capital project that provides a rate of return equal to or greater than the hurdle or

estimated cost of capital and still have an acceptable project; as long as the project’s IRR

is equal to or greater than the cost of capital, the project will be acceptable.

c. Range of the Cash Flows

d. Range of the Life of the Asset

i. Asset life is related to many factors, some are controllable while others are not.

project.

5. Sensitivity analysis does not reduce the uncertainty surrounding the estimate of each variable,

K. Postinvestment Audit

1. A postinvestment audit is the process of gathering information on the actual results of a capital

project and comparing them to the expected results.

2. The postinvestment audit process provides a feedback or control feature both to the persons who

submitted and those who approved the original project information.

capital project.

5. Postinvestment audits provide managers with information that can help them make better capital

investment decisions in the future.

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LO.10: (Appendix 1) How are present values calculated?

L. Time Value of Money

1. Future value (FV) refers to the amount to which a sum of money invested at a specified interest

of interest.

3. Future and present values depend on three things: amount of the cash flow, rate of interest, and

timing of the cash flow.

4. The discount rate is the rate of return used in present value calculations; a present value is a

future value discounted back the same number of periods at the same rate of interest.

original investment or principal amount.

6. Compound interest is a method of determining interest in which interest that was earned in prior

on both principal and interest.

7. The compounding period is the time between each interest computation.

M. Present Value of a Single Cash Flow

rate of interest.

2. Present values are computed as follows:

PV = FV ÷ (1 + i)n

i = interest rate per compounding period

n = number of compounding periods

N. Present Value of an Annuity

a. An ordinary annuity is a series of equal cash flows, each being received or paid at the end

of a period.

2. Situations often exist in which an annuity is “nested” or surrounded by unequal flows.