Topic 6 - Capital Budgeting Applications (Part 2)

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This article is a topic within the subject Business Finance.

Contents

Required Reading

Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 261-293.

Additional Evaluation Criteria

Discounted Payback

Future cash flows are discounted to a present value before they are accumulated – an extension of the payback period method. For independent projects the decision rule is arbitrary, for mutually exclusive projects the shortest discounted payback is chosen.

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  • Advantages: Simple to estimate, clear mutually exclusive decision rule, time value of money accounted for
  • Disadvantages: Arbitrary decision rule (max payback period benchmark), CF’s after payback are ignored

Modified IRR

This technique is a variation of the IRR. MIRR assumes cash flows are reinvested at the discount rate. For independent projects the accept projects with an MIRR > hurdle rate, for mutually exclusive projects the highest MIRR is chosen

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  • Advantages: Simple decision rule, easy to understand, no multiple MIRR’s in non-conventional CF’s, CF’s assumed to be reinvested at the discount rate
  • Disadvantages: Doesn’t account for project size or life span (terminal year of longer project is used – use $0 to fill in the gaps of the other project), complicated calculation,

Example

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Further Project Evaluation Example – Cost Cutting

We need to forecast cash flows, estimate the cost of capital, discount CF’s & accept if the NPV > 0.

  • Initial Outlay = $155,000
    • Outlay = $200,000
    • NOWC (Net Operating Working Capital) Saving = - $45,000
  • Operating Cash Flows = $56,100
    • (Revenue – Costs)(1-t) = $36,600
    • Depreciation Tax Shield = $19,500
    • OR Net Profit = $6,100 & Depreciation = $50,000
  • Terminal Cash Flows = - $26,700
    • Net Salvage = $30,000(1-t) = $18,300
    • NWC return = -$45,000
  • NPV = -$12,768

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Analysing Project Risk

[1] Although risk is already included in the required rate of return, the risks associated with the assumptions used to forecast future cash flows can lead to variable forecasts. This can be analysed via sensitivity, break even & simulation analysis.

Sensitivity Analysis (Variation Of Scenario Analysis)

This analysis shows which variables deserve most attention.

This analyses the effect of changing 1 or more input variables to observe the effects on the results. Pessimistic, base & optimistic estimates can be made for each value. The NPV is calculated using the expected estimate for each variable except 1 & the process is repeated for pessimistic, base & optimistic estimates. The difference between the pessimistic & optimistic NPV is calculated for each variable.

Break-Even Analysis

BEP analysis is a form of sensitivity analysis as is measures the sensitivity of profitability to the variation in 1 variable e.g. sales.

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Simulation Techniques

Simulation involves changing all variables whose values are uncertain. A computer is able to generate cash flows to form a probability distribution.

Scenario Analysis

Scenario Analysis measures the impact on NPV when several variables in a project are altered at the same time (usually best, base & worse case scenarios). The difference between the best & worst indicates the level of risk.

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Sensitivity/BEP Analysis/Scenario Example

Operating Cash Flow = $714,000 + $130,000 = $844,000

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End

This is the end of this topic. Click Business Finance to go back to the main subject page for Business Finance

References

Textbook refers to Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010.

  1. Essentials of Corporate Finance (2nd Australian and New Zealand edition), by Stephen A. Ross, Rowan Traylor, Ron Bird, Randolph W. Westerfield and Bradford D. Jordan, McGraw Hill Irwin, 2010., pp. 279-283
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