2nd Exam
Chapter 10 Capital budgeting is fundamental to the FM decision-making process; focused on investment in fixed assets. It involves measuring the incremental cash flows associated with investment proposals and the evaluation of the attractiveness of such cash flows relative to the project’s costs. At issue is the estimation of those cash flows based on various decision criteria and how to adjust for riskiness of a given project or combination of projects. Incremental after-tax cash flows are initial outlay, differential cash flows over the projects life, and terminal cash flows. Relevant information needed for an adequate project assessment from a cash flow perspective are:
Initial: Purchase price; installation fees; training; inventory and related start-up costs
Differential annual cash flows: Changes in earnings (before interest and taxes); tax impact; impact on depreciation; change in net working capital; and change in capital spending.
Terminal cash flow: free cash flow (over project’s life) and recapture of inventory investment (working capital)
In order to make sense of the derived numbers, those beyond present day must be converted to present value to have a basis for comparison to other projects over shorter or longer periods of investment.
Methods for evaluating projects:
Payback: number of years required to recover initial investment. Adds cash flows up until they equal initial fixed investment. Ignores cash flows that occur after payback period and does not consider time value of money.
Present-value (PV): Net present value of an investment is the PV of the cash in flows less the PV of the cash outflows.
Profitability Index: ratio of the PV of the expected future net cash flows to the initial cash outlay.
IRR: discount rate that equates the PV of the project’s future net cash flows with project’s initial outlay.
Expected Return: the expectation with an investment is it will return increased value to the firm, in the form
Initial: Purchase price; installation fees; training; inventory and related start-up costs
Differential annual cash flows: Changes in earnings (before interest and taxes); tax impact; impact on depreciation; change in net working capital; and change in capital spending.
Terminal cash flow: free cash flow (over project’s life) and recapture of inventory investment (working capital)
In order to make sense of the derived numbers, those beyond present day must be converted to present value to have a basis for comparison to other projects over shorter or longer periods of investment.
Methods for evaluating projects:
Payback: number of years required to recover initial investment. Adds cash flows up until they equal initial fixed investment. Ignores cash flows that occur after payback period and does not consider time value of money.
Present-value (PV): Net present value of an investment is the PV of the cash in flows less the PV of the cash outflows.
Profitability Index: ratio of the PV of the expected future net cash flows to the initial cash outlay.
IRR: discount rate that equates the PV of the project’s future net cash flows with project’s initial outlay.
Expected Return: the expectation with an investment is it will return increased value to the firm, in the form