... This student will analyze two different companies that cost $250,000 each to determine which company is the best investment. Overview of Net Present Value One method used to determine which corporation to acquire is the net present value (NPV). The NPV “of an investment proposal is equal to the present value of its annual free cash flows less the investment cash outflow to purchase the asset and put it in operating order” (Keown, 2014, pg. 310). In other words, it is the cash inflow that consists of “incremental revenues, reduction of costs, and release of working capital compared to the cash outflows that consists of the initial investment, repairs, maintenance, and operating costs of an asset” (Accounting For Management, 2012, pg. 1). If the NPV value is positive, the asset should be acquired. Overview of Internal Rate of Return Another method used to determine which corporation to acquire is the internal rate of return (IRR). The IRR is “the discount rate that equates the present value of the project free cash flows with the project initial cash outlay” (Keown, 2014, pg. 316). In other words, “it is the rate of return promised by an investment project over its useful life” (Accounting For Management, 2012, pg. 1). If the IRR of an investment is less than the cost of capital of that investment than it is rejected unless other factors indicate it...
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...Key differences between the most popular methods, the NPV Method and IRR Method, include: * NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return; * Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not; * The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm); * However, the IRR Method does have one significant advantage – managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally, * While both the NPV Method and the IRR Method are both discounted cash flow models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows is preferable to a larger project that will generate more cash. * Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation. (Wilkinson 2013) It makes this adjustment using a "discount rate" that takes into account inflation, the risk of the project and the cost of capital -- either interest paid...
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...menentukan biaya modal (cost of capital) yg tepat untuk mendiskon aliran kas proyek. 4. Dengan menggunakan nilai waktu uang, aliran kas masuk yang diharapkan digunakan untuk memperkirakan nilai aktiva.. 5. Terakhir, nilai sekarang dari aliran kas yg diharapkan dibandingkan dengan biayanya. Basic Terminology * Independent Vs. Mutually Exclusive Projects Independent project adalah proyek di mana aliran kas tidak berhubungan satu sama lain. Penerimaan pada suatu proyek tidak mengeliminasi proyek lainnya untuk pertimbangan lebih lanjut. Mutually exclusive project adalah proyek yang mempengaruhi satu sama lain. Jadi penerimaan pada satu proyek akan mengeliminasi proyek lainnya; yang mmepunyai fungsi yang mirip; untuk pertimbangan lebih lanjut. * Unlimited Fund Vs. Capital Rationing Unlimited fund adalah keadaan keuangan di mana perusahaan dapat menerima semua independent project yang menyediakan pengembalian yang dapat diterima. Capital rationing adalah keadaan keuangan di mana perusahaan hanya memiliki satu biaya tetap yang tersedia untuk pengeluaran-pengeluara, sehingga proyek-proyek yang ada harus bersaing untuk dipilih. * Accpet-Reject Vs. Ranking Approach Accept-reject approach adalah evaluasi pengeluaran cadangan modal untuk menentukan apakah proyek sesuai dengan minimal kriteria yang ditentukan. Ranking approach adalah mebuat peringkat dari pengeluaran modal untuk proyek dalam dasar beberapa pengukuran yang telah ditentukan, seperti tingkat pengembalian. Metode-Metode...
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...Quiz 11 Cost of Capital 1(11-2) NPV and IRR F I Answer: b EASY [i]. A basic rule in capital budgeting is that If a project's NPV exceeds its IRR, then the project should be accepted. a. True b. False 2(11-2) Mutually exclusive projects F I Answer: b EASY [ii]. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR. a. True b. False 3(11-3) IRR F I Answer: b EASY [iii]. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR. a. True b. False 4(11-4) Multiple IRRs F I Answer: b EASY [iv]. The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False 5(11-5) Reinvestment rate assumption F I Answer: b EASY [v]. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False 6(11-6) Modified IRR F I Answer: b EASY [vi]. When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being...
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...NPV vs IRR NPV is Net Present Value is the present value of the future net cash flows from an investment project, and is one of the main ways to evaluate an investmentIRR - The Internal Rate of Return method is the process of applying a discount rate results in the present value of future net cash flows equal to zeros. NPV is calculated in terms of currency while IRR is expressed in terms of the percentage return a firm expects the capital project to return. The IRR and NPV rules can be used for evaluating projects and more often than not the results are very similar. The NPV method is preferred over the IRR because it calculates additional wealth and the IRR method does not. Whenever there is a conflict between NPV and IRR the correct answer is provided by NPV. NPV is stated as the most acceptable tool to compare alternative investments as compared to Internal Rate of Return (IRR) and payback (Gitman, 2009). The major limitation to the IRR is that it uses one single discount rate for evaluating all its investments and without modification does not take into consideration changes in discount rates which would make it inadequate to be used for long term projects. It uses one single discount rate to evaluate every investment. If the IRR is above the discount rate the project is feasible, if it is below, the project is not feasible. There is however, one possible advantage to the IRR, managers returns managers tend to better understand the concept of returns stated in percentages...
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... NPV or net present value illustrated as the present value of an investment’s annual free cash flow less the investment’s initial outlay (Keown, Petty, & Martin 2014 Pg. 314). While assessing both Corporation A and Corporation B, NPV formula’s represented by (present value of all the future annual free cash flows) - (the initial cash outlay). Calculations of Corporation A, has a 10% rate of return and the present value of the free cash flow is $270,980. Subtracting the initial $100,000 outlay leaves an NPV of $170,980. Corporation B has an 11% rate of return and the present value of the free cash flow is $290,252. Subtracting the initial $150,000 outlay leaves an NPV of $140,252. Analyzing the results, the NPV tells the value of the project and if that particular project is worth the investment. If the NPV shows a positive result, it is accepted, if it returns negative, it is automatically rejected. With the assessment of both corporations, the values are greater than zero therefore both projects would be accepted. However, because Corporation A has a higher rate of return at the end of the five years, this would be the recommended corporation out of the two. NPV is essential when dealing with capital-budgeting decisions. It is most useful because it is a tool that evaluates free cash flows opposed to accounting profits. It also allows the recognition of time value of money in regard to benefits and costs and the comparison of logic. IRR or Internal...
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...Conceptual questions * Sunk cost-not included/take out vs. opportunity cost-included Chapter 7 * Constant growth model * Non-constant growth situation Chapter 9 * Component cost * Weighted avg cost of capital * Subtract interest cost-tax ded. * Cost of debt-tax ded. * Preffered * Stock * Instead of using coupon rate for insurance-use yield to maturity * Yield of maturity is more indicative to use-will be given * Calculate some component cost then calculate weighted avg. of those * SML equation-component cost of equity * Dividend discount model out of Chapter 7 * Before tax remember to tax effected after remember not to tax affected * What will new debt be financed at * 9-4 practice/floatation cost/ Preferred * Problems at end of 9 Chapter 10 * Payback method-does not take time value of money in account/nor does it take take cash flows after payback period * Discount method does take time value of money in account but still does not take cash flow * IRR not as good NPV-discount rate that drives NPV to 0 * Changed weighted avg. of capital it does not change IRR * Critisim of IRR same internal rate of return assums cash flows will be reinvested-unrealistic * Can get more than 1 IRR-if more than one change * NPV sum of cash flows if positive-give it a green light go with it /Negative you should not do it * Is IRR-greater is what you want * NNR adjusted cash flow...
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...common stock Capital structure weights (wd, wp, wc) based on book values. The weight is the dollar amount of the capital type divided by total assets. The sum of the weights must equal 100%. Calculate the breakpoint: the amount of new capital a firm can raise before it uses up its level of retained earnings and has to issue new common stock to finance its investments. $retained earnings $net income x (1 – dividend payout ratio) Breakpoint = -------------------------------- = -------------------------------------------------------- Common equity weight wc Determine relevant source of common equity (retained earnings vs. new common) based upon the capital budget and the breakpoint. CHAPTER 11 BASICS OF CAPITAL BUDGETING Know the effect of understated/overstated WACC on project...
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...Capital Budgeting Analysis Amanda Kocanda, DeUndre’ Rushon, HuongTran,& Morgan Gibreal MBA 612, Financial Strategy October 28, 2014 Bellevue University Abstract Within this paper, an overview of the general capital budgeting process and how it is implemented within organizations is defined and reported. Key terms related to capital budgeting are also defined. Risk analysis based on the Net Present Value (NPV) is performed on the salvage values before and after sales tax values along with the different sale ranges. Keywords: NPV, NPV Profile, NPV, IRR, multiple IRRs, ranking conflict of NPV vs. IRR, payback period, profitability index, discount rate, cost of capital concept, cash flow analysis, cash flow timeline, conventional cash flow stream, non-conventional cash flow stream, sunk cost, opportunity cost, independent projects, mutually exclusive projects Overview of the Capital Budgeting Process Every business requires some source of funds to maintain operation and competitive advantages. Whether it’s a manufacturing or servicing firm, it requires financing. Financing sources can be obtained through debt, bond issuance, bank loan, equity, and issuance of preferred and/or common stock. The amount of debt and equity builds the firm's capital structure. The firm's corporate or business strategy is the proportion of capital structure it needs to finance its operation. The combination of debt and equity totals the cost of capital for the firm. The...
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...present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. 2.) Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project’s cash flows come in the early years, while most of the other project’s cash flows occur in the later years. The Two NPV profiles are given below: Which of the following statements is CORRECT? A-More of Project A’s cash flows occur in the later years. 3.) Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? E-If the 4-year payback results in accepting just the right set of projects under average economic conditions, and then this payback will result in too few long-term projects when the economy is weak. 4.) You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the project’s risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15, 000 and two cash flows: $110,000 at the end of Year 1 and $100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for its project is 10%. At 10%, the NPV is $2,355.37, but you...
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...assignment * Broad idea of assignment Part A : understanding the method Part B : theoretical method NO TAX requirement ! Valuation method .. NPV, IRR , Payback method. NPV – A rule that company use whether accept or reject the project. Based on discount factor , interest rate. Study guide! – NPV (number of calculation, examples) IRR – a discount rate that gives a zero NPV… cash flow tend to zero. NPV you know initial initial investment , cash flow, discount rate IRR you know initial initial investment , cash flow, but predict your discount rate You cant rely excel ! (don’t use the functioin) Pay back method : how long it takes your initial investment … ? 2 years etc Pay back period --- every company can decide their payback period. Whether they accept and reject the project. Two companies in the same sector.. they may have two payback period. Evaluation method.. accounting measure. NPV rule : accept investment project which cash flow worth more than the cost of financing the projects. IRR rule : accept the project if IRR Is greater than the cost of capital. If your IRR higher than discount rate , accept the project. Pay back : payback period is less than specified payback period. | If se NPV .. you should accept the project..and IRR rule.. but payback period not really.. it depends to the company Depreciation vs capital allowance. (not related to assignment) Depreciation: using the asset, reducing the value. (non cash expense) .. reflective to the tax. Cash...
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...Competition Bikes, Inc.Financial AnalysisJET2 Task 3 Introduction Competition Bikes, Incorporated (CBI) has decided to weigh their options for expansion into Canada by either acquiring or merging with Canadian Bikes, Inc. This report will discuss the proposed expansion and make recommendations based on the company's capital structure. Capital structure can be described as how a business finances its assets. There are two main types of capital: Equity and debt. Capital structure is usually a mix of debt, preferred stock, and common stock that the company can use for expansion and to remain financially healthy. The key is to choose the right mix in order to maximize shareholder return. A1. Capital Structure Capital structure is generally defined as how a company finances its assets. It is measured as a percentage of debt and equity (common and preferred stock). Potential investors tend to look positively on a company that has more equity and less debt. The best capital structure approach for CBI to take is to implement the 50% Preferred and 50% Common Stock scenario. This alternative provides the best overall way to improve CBI's financial position with strong capital structure while maximizing shareholder return. A1a. A review of Canadian Bikes data over five years indicates consistently increased earnings before interest and taxes (EBIT), increased net profit, and increased shareholder returns (EPS). Offering the 50% preferred and 50% common stock results in the highest...
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...1. (1) Option #3 was for Stryker Instruments to manufacture its own PCBs in its own facility near company headquarters. (2)Benefits for option 3: ● Better control the quality, delivery and cost; ● Maintain the business stability; ● Supply PCBs to other Stryker businesses; ● Be able to implement cost shift and avoid tax; (3) Risks for option 3: ● Carry the inventory; ● Incur large capital outlay and sunk cost; ● Increase headcount, payroll and other expenditures (materials, infrastructure, R&D, maintenance, PP&E and depreciation) of Stryker; ●Bear the risk that the equipment may be outdated; (4) Compared with option #1: ●Benefit: no capital outlay; to some extent can protect future against disruptions with lower cost; flexibility; ●Risk: instability in quality, cost, delivery and responsiveness; Compared with option #2: ●Benefit: can improve quality of the supplies by increasing business with the supplier; ●Risk: the possibility of bankruptcy and weak financial performance of supplier; the sole supplier can strongly affect Stryker’s performance; coordination problem. 2. (1) Followings are the key assumptions of our write up: ● Stryker Instruments incurred all capital expenditures including (construction and improvements, furnishings and non-manufacturing equipment, communication equipment and IT infrastructure and capital equipment) in year 2003, before the implementation...
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...But it all costs • Capital expenditure on new projects or purchases (fixed assets) needs to be planned • Capital is always rationed Scenario: • Your business wishes to expand its product line • It is considering Products A and B but it can only afford to do one. • How does it decide? What main factors affect the investment decision • How much will it cost ? Investment appraisal methods used in practice • How much will I get back ? • When will I get the income ? • 4 main techniques available ranging from simple to moderately complex MULTIPLE APPRAISAL METHODS: Non‐discounted cash flow techniques: 1. Payback period (PBP) 2. Accounting rate of return (ARR/ROCE/ROI) Discounted cash flow techniques(DCF): 3. Net Present Value (NPV) 4. Internal Rate of Return (IRR) 6 1 MBA7001 Accounting for Decision-Makers Week 6 Lecture – Capital Investment Appraisal Objectives (1)...
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...Capital Budgeting Techniques | | GLOSSARY Capital Budget: (1) The amount of money set aside for the purchase of fixed assets (e.g., equipment, buildings, etc.). Also, (2) a request for authorization to purchase new fixed assets. Mutually Exclusive Proposals: Consideration of two or more assets that perform the same function. If one is chosen for purchase, the others are automatically rejected. Profitability Index: A ratio of the present value of the benefits (PVB) to the present value of the costs (PVC). The index is used instead of Net Present Value (i.e., PVB - PVC) when evaluating mutually exclusive proposals that have different costs. As the picture above illustrates, the capital budgeting decision may be thought of as a cost-benefit analysis. We are asking a very simple question: "If I purchase this fixed asset, will the benefits to the company be greater than the cost of the asset?" In essence, we are placing the cash inflows and outflows on a scale (similar to the one above) to see which is greater. A complicating factor is that the inflows and outflows may not be comparable: cash outflows (costs) are typically concentrated at the time of the purchase, while cash inflows (benefits) may be spread over many years. The time value of money principle states that dollars today are not the same as dollars in the future (because we would all prefer possessing dollars today to receiving the same amount of dollars in the future). Therefore, before we can place...
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