FIN3701_ Financial Management_ Study Notes Summary.

FIN3701_ Financial Management_ Study Notes Summary. International Capital Budgeting  International capital budgeting analysis differs from purely domestic analysis because: -Cash inflows and outflows occur in a foreign currency. -Foreign investments potentially face significant political risks.  Despite these risks, the pace of foreign direct investment has accelerated significantly since the end of World War II. Expansion versus replacement cash flows  Estimating incremental cash flows is relatively straightforward with expansion projects.  With replacement projects, incremental cash flows are computed by subtracting existing project cash flows from the new project’s expected cash flows. Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. Finding the initial investment Installed cost of the new asset Asset cost + Installation cost - After-tax proceeds from sale of existing asset Proceeds from sale of existing asset -tax on sale of the existing asset +/- Change in net working capital INITIAL INVESTMENT Operating Cash Flow Revenue -Expenses EBDIT -Depreciation EBIT -Tax NOPAT + Depreciation OCF Finding the Terminal Cash Flow After-tax proceeds from sale of new asset Proceeds from sale of new asset ± Tax on sale of new asset -After-tax proceeds from sale of old asset Proceeds from sale of old asset ± Tax on sale of old asset ± Change in net working capital TERMINAL CASH FLOW Examples of relevant cash flows  Cash inflows and outflows Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved.  Changes in working capital  Terminal cash flows  Depreciation  Taxation costs Capital budgeting techniques NPV technique Decision criteria NPV 0, Accept the project. NPV 0, Reject the project. IRR technique Decision criteria IRR cost of capital, Accept the project. NPV cost of capital, Reject the project. Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. STUDY UNIT 2-CAPITAL BUDGETING TECHNIQUES Payback Period  Is the length of time required to recover the cost of an investment.  The payback period of a given investment or project is an important determinant of whether to undertake the position or project, as longer payback periods are typically not desirable for investment positions. Payback Period = Cost of Project / Annual Cash Inflows Payback Period Strengths and Weaknesses Strengths:  Easy to use and understand  Can be used as a measure of liquidity  Easier to forecast on short term than long term flows Weaknesses:  Does not account for TVM  Does not consider cash flows beyond the PBP  Cutoff period is subjective Net Present Value NPV is the present value of an investment project’s net cash flows les the project’s initial cash outflow. Calculation Methods and Formula Step 1  Determine the present value of net cash inflows from a project or asset.  The net cash flows may be even (i.e. equal cash inflows in different periods) or uneven (i.e. different cash flows in different periods).  When they are even, present value can be easily calculated by using the present value formula of annuity. Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved.  For uneven, we need to calculate the present value of each individual net cash inflow separately. Step 2  Subtract the initial investment on the project from the total present value of inflows to arrive at net present value. When cash inflows are even: In the above formula, R is the net cash inflow expected to be received each period; i is the required rate of return per period; n are the number of periods during which the project is expected to operate and generate cash inflows. When cash inflows are uneven: Where, i is the target rate of return per period; R1 is the net cash inflow during the first period; R2 is the net cash inflow during the second period; R3 is the net cash inflow during the third period, and so on ... Advantage and Disadvantage of NPV Advantage Net present value accounts for time value of money. Thus it is more reliable than other investment appraisal techniques which do not discount future cash flows such payback period and accounting rate of return. Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. Disadvantage It is based on estimated future cash flows of the project and estimates may be far from actual results. Internal Rate of Return.(IRR) IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. Profitability Index  Is a cost–benefit (C/B) ratio.  It is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of theinvestment.  The PI can be computed as follows:PI = present value of cash inflows ÷ initial cash outflow NPV vs. IRR -Each of the two rules used for making capital-budgeting decisions has its strengths and weaknesses. -The NPV rule chooses a project in terms of net dollars or net financial impact on the company, so it can be easier to use when allocating capital. - However, it requires an assumed discount rate, and also assumes that this percentage rate will be stable over the life of the project, and that cash inflows can be reinvested at the same discount rate. -The appeal of the IRR rule is that a discount rate need not be assumed, as the worthiness of the investment is purely a function of the internal inflows and outflows of that particular investment. -However, IRR does not assess the financial impact on a firm; it only requires meeting a minimum return rate. Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. - The NPV and IRR methods can rank two projects differently, depending on thesize of the investment. STUDY UNIT 3 RISK IN THE CAPITAL BUDGETING PROCESS There are numerous kinds of risks to be taken into account when considering capital budgeting including:  corporate risk  international risk (including currency risk)  industry-specific risk  market risk  stand-alone risk  project-specific risk Each of these risks addresses an area in which some sort of volatility could forcibly alter the plan of firm managers. For example, market risk involves the risk of losses in position due to movement in market positions. There are different ways to measure and prepare to deal with risks as well. One such way is to conduct a sensitivity analysis. 1. Sensitivity analysis is the study of how the uncertainty in the output of a model (numerical or otherwise) can be apportioned to different sources of uncertainty in the model input. 2. A related practice is uncertainty analysis which focuses rather on quantifying uncertainty in model output. Ideally, uncertainty and sensitivity analysis should be run in tandem. Another method is scenario analysis, which involves the process of analyzing possible future events by considering alternative possible outcomes. For example, a financial institution might attempt to forecast several possible scenarios for the economy (e.g., rapid growth, moderate growth, slow growth), and it might also attempt to forecast financial market returns (for bonds, stocks, and cash) in each of those scenarios. It might consider sub-sets of each of the possibilities. It might further seek to determine correlations and assign probabilities to the scenarios. Then it will be in a position to consider how to distribute assets between asset types (i.e., asset allocation). The institution can also calculate the scenarioDownloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. weighted expected return (which figure will indicate the overall attractiveness of the financial environment). It may also perform stress testing, using adverse scenarios. Incorporate risk into the capital budgeting process by applying risk-adjusted discount rates and certainly equivalents Methods for incorporated project risk: 1. Certainty equivalent method, in which the expected cash flows are adjusted to reflect project risk: Risky cash flows are scaled down because the riskier the flows, the lower their certainty equivalent values. 2. The second is the risk-adjusted discount rate method, where differential project risk is dealt with by changing the discount rate: Average-risk projects are discounted at the firm’s corporate cost of capital, above-average-risk projects are discounted at a higher cost of capital, and below-average-risk projects are discounted at a rate below the corporate cost of capital. The risk-adjusted discount rate method is used by most companies, so we focused on it in earlier chapters. Refer to this link for more information and worked examples on incorporate risk. Determine the optimal capital budget under the capital rationing constraint Capital Rationing Firms often operate under conditions of capital rationing – they have more acceptable independent projects than they can fund. In theory, capital rationing should not exist – firms should accept all projects that have positive NPVs. However, in practice, most firms operate under capital rationing. Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. Generally, firms attempt to isolate and select the best acceptable projects subject to a capital expenditure budget set by management. The internal rate of return approach is an approach to capital rationing that involves graphing project IRRs in descending order against the total dollar investment to determine the group of acceptable projects. The graph that plots IRRs in descending order against the total dollar investment is called the investment opportunities schedule (IOS). The problem with this technique is that it does not guarantee the maximum dollar return to the firm. This is show below: Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. The Net Present Value Approach. The net Present value Approach is an approach to capital rationing that is based on the use of present values to determine the group of projects that will maximise owners’ wealth. It is implemented by ranking projects on the basis of IRRs and then evaluating the present value of the benefits from each potential project to determine the combination of projects with the highest overall present value. Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. Capital Budgeting Refinements: Comparing Projects with Unequal Lives The financial manager must often select the best of a group of unequal-lived projects. If projects are independent the length of the project lives is not critical. Downloaded by Patric Sipho Zumdahl () lOMoARcPSD| © 2017 Together We Pass. All rights reserved. But when unequal – lived projects are mutually exclusive, the impact of differing lives must be considered because the projects do not provide service over comparable time periods