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Learning Outcomes
introduction
to capital budgeting
investment
decision rules
net present value (NPV) rule 3 building blocks
payback rule payback period(soon is better)
internal rate of return (IRR) rule
choosing between projects with differences in
scale
equivalent annual annuity (EAA) rule for
evaluating projects with different lives
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Learning Outcomes
capital
budgeting decision
capital budgeting process
A positive incremental cash flow means that the
incremental free cash flows company's cash flow will increase with the acceptance
of the project.
tax depreciation vs. accounting depreciation
(extra)
post
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net
present
value rule
payback
rule
internal
rate of
return
rule
equivalent
annual
annuity rule
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rule
independent projects: undertake
. it if the NPV>0, +ve
mutually exclusive projects: choose
. the one with the highest NPV
given that it is > 0
other issues
NPV profile: a graph of a projects NPV over a
range of discount rates
internal rate of return (IRR): discount rate that
renders NPV equal to zero (common mistake:
IRR is different from the IRR rule discussed
later)
Topic 3 Investment Decision Rules and Capital Budgeting
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$500
$400
$250
$500
$400
$250
NPV =
+
+
$1,000
2
3
1 + 10% (1 + 10%)
(1 + 10%)
= $26.95
As NPV < 0, the decision is to reject the project.
Topic 3 Investment Decision Rules and Capital Budgeting
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$160
$120
$80
$40
region of acceptance:
NPV > 0 when r < IRRstill positive
discount rate
$0
($40) 0%
($80)
($120)
2%
4%
6%
8%
IRR = 8.27%
set NPV=0, IRR= the discount rate
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Payback Rule
payback
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Payback Rule
advantages
simple
to compute
favors liquidity
disadvantages
no guidance as to correct payback cutoff
ignore cash flows after cutoff completely
ignore time value of money
biased against long-term projects such as
research and development or new projects
not necessarily consistent with maximizing
shareholder wealth
Topic 3 Investment Decision Rules and Capital Budgeting
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year
-$2,000
$1,000
$1,500
-$2,000
$500
$1,000
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$10,000
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$2,000 $1,000
payback( A ) = 1 +
= 1.67 years
$1,500
$2,000 - $500 - $1,000
payback(B) = 2 +
= 2.05 years
$10,000
As project A has the shorter payback period, the decision
is to accept project A.
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decision
rule
independent projects:
.
mutually exclusive projects:
.
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year
-$2,000
$1,000
$1,500
-$2,000
$500
$1,000
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$10,000
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year
-$2,000
$909.09
$1,239.67
-$2,000
$454.55
$826.45 $7,513.15
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$2,000 $909.09
payback( A ) = 1 +
= 1.88 years
$1,239.67
$2,000 - $454.55 - $826.45
payback(B) = 2 +
= 2.10 years
$7,513.15
As project A has the shorter discounted payback period, the
decision is to accept project
assume cash flow regularly (end of each year)
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in
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-$200
$150
$150
-$200
$100
$200
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Consider
year
0
$500K
-$125K
-$150K
-$175K
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2
3
1 + IRR (1 + IRR)
(1 + IRR)
IRR = 8.90%
As IRR > 6%, the decision is to accept project.
$150K
$200K
$250K
NPV =
+ $500K
2
3
1 + 6% (1 + 6%)
(1 + 6%)
= $29.41K
As NPV < 0, the decision is to reject project.
still work for the NPV rule
Topic 3 Investment Decision Rules and Capital Budgeting
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cost of capital
= 6%
2%
4%
6%
region of rejection:
NPV <0 when r < IRR
region of acceptance:
NPV > 0 when r > IRR
8%
10%
($80)
($100)
Topic 3 Investment Decision Rules and Capital Budgeting
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Consider
0
-$75
$200
-$128
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1 + IRR (1 + IRR)2
IRR = 6.67% or 60%
As 60% > 12%, the decision is to accept project.
As 6.67% < 12%, the decision is to reject project.
$200
$128
NPV =
$75 = $1.53
2
1 + 12% (1 + 12%)
As NPV > 0, the decision is to accept project.
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IRR =
60%
discount rate
40%
50%
60%
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70%
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80%
ranking
-$100
-$50
$45
$23
$45
$23
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$45
$23
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cross-over rate
= 15.28%
$30
cost of capital
= 12%
$20
$10
IRR(B) =
18.01%
IRR(A) =
16.65%
NPV(A) = $8.08
NPV(B) = $5.24
$0
0%
2%
4%
6%
($10)
discount rate
Topic 3 Investment Decision Rules and Capital Budgeting
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-$60
$50
$50
-$60
$90
$30
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$50
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IRR(B)
there
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$100
$80
undertake A
$60
NPV(A) = $45..32
$40
NPV(B) = $35.83
undertake B
IRR(A) = IRR(B) =
64.67% 78.08%
$20
$0
($20)
0%
20%
40%
60%
80%
100%
discount rate
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rule
higher Annuity
mutually exclusive projects:
.
important considerations
required life: the life of a machine is more than
the years to use (machine life not equal to project life)
replacement cost: a change in technology may
reduce the replacement cost in the future
then use NPV*
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-C0
C1
C2
EAA
EAA
.....
N-2
N-1
CN-2
CN-1
CN
EAA
EAA
NPV
EAA
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-$9,000
$4,000
$4,000
$4,000
-$8,000
$5,000
$5,000
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$1,692.05 = EAA( A ) *
* 1
3
6%
(1 + 6%)
EAA( A ) = $633.02
1
1
$1,166.96 = EAA(B) *
* 1
2
6%
(1 + 6%)
EAA(B) = $636.50
as EAA(B) > EAA(A), the decision is to buy machine B
both are perpetuity
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feedback
financial
assumptions
statements and
market data
analysis
planning
current financial
pro-formas, cash
position and past
and capital
operating
budgets, financial
performance
plans
control
actual results
implementation of
financial plans
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estimate
discount rate
project cash
flows
reject project
feedback
post audits
determine NPV
keep records
<0
NPV>?
>0
accept project
and implement
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purchase
equipment
incremental
revenue
sale of equipment
(net of taxes)
incremental costs
initial development
cost
increase in working
capital
shutdown costs
taxes
change in net
working capital
decrease in net
working capital
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The
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A
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basis
A
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cash flows
A
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A
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After-Tax Basis
revenue
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Incremental Basis
in
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Incremental Basis
standalone
estimate
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Incremental Basis
similarly,
project B
if incremental NPV > 0, accept project A
if incremental NPV < 0, accept project B
Topic 3 Investment Decision Rules and Capital Budgeting
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income
determine
free
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operating
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expenditures: costs of buying new longterm assets, including shipping and installation
costs (cash outflow in year 0)
estimate the initial investment in property, plant
and equipment
capital expenditures as cash outflows, which
do not affect net income
depreciation expenses as non-cash items
which reduce net income, but not cash flows
difference between net income and cash flows
(quick reminder: why different?)
Topic 3 Investment Decision Rules and Capital Budgeting
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selling
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the
the
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beginning net
book value of
machine
$1,000,000
$800,000
$600,000
$400,000
$200,000
ending net
depreciation
book value
expense
of machine
effect on
income
before tax
effect on cash
flows
$1,000,000
$800,000
$600,000
$400,000
$200,000
$0
$0
-$200,000
-$200,000
-$200,000
-$200,000
-$200,000
-$1,000,000
$0
$0
$0
$0
$33,000
$200,000
$200,000
$200,000
$200,000
$200,000
incremental cash
flow from disposal
of machine
Topic 3 Investment Decision Rules and Capital Budgeting
difference between
income and cash flows
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Depreciation Method in US
actual
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MACRS
only for
half a year
depreciation
rate on each
year
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Example: MACRS
Suppose
year
depreciati beginning
ending
MACRS %
on
book value book value
1
2
3
4
5
6
total
20.00%
32.00%
19.20%
11.52%
11.52%
5.76%
100.00%
$2,400
$3,840
$2,304
$1,382
$1,382
$691
$12,000
$12,000
$9,600
$5,760
$3,456
$2,074
$691
$9,600
$5,760
$3,456
$2,074
$691
$0
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book
value in
IRS
records
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annual
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beginning
initial
annual
total
ending
book value allowance allowance allowance book value
$12,000
$7,200
$1,440
$8,640
$3,360
$3,360
$1,008
$1,008
$2,352
$2,352
$706
$706
$1,646
$1,646
$494
$494
$1,152
$1,152
$346
$346
$807
$807
$242
$242
$565
$565
$169
$169
$395
$395
$119
$119
$277
$277
$83
$83
$194
$194
$58
$58
$136
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talk
estimate
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to notice
product life cycle: initial low sales (start-up),
accelerating sales (growth), level sales
(maturity) and declining sales (decline)
prices and costs increase with inflation and
decline with technological advancement
competition tends to drive profit margins down
over time
EBIT = incremental revenue incremental costs depreciation
Topic 3 Investment Decision Rules and Capital Budgeting
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growth
maturity
decline
time
Topic 3 Investment Decision Rules and Capital Budgeting
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year
incremental revenue
incremental cost
depreciation
EBIT
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$75,000 -$175,000 -$175,000 -$175,000 -$175,000 -$175,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000
-$75,000 $150,000 $150,000 $150,000 $150,000 $150,000
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year
incremental revenue
incremental cost
depreciation
EBIT
income tax @34%
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$75,000 -$175,000 -$175,000 -$175,000 -$175,000 -$175,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000
-$75,000 $150,000 $150,000 $150,000 $150,000 $150,000
-$25,500
$51,000
$51,000
$51,000
$51,000
$51,000
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tax
difference
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earnings
= (incremental revenue incremental cost
depreciation) * (1 tax rate)
= incremental EBIT * (1 tax rate)
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year
incremental revenue
incremental cost
depreciation
EBIT
income tax @34%
incremental earnings
0
-$75,000
-$75,000
-$25,500
-$49,500
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$175,000 -$175,000 -$175,000 -$175,000 -$175,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000
$150,000 $150,000 $150,000 $150,000 $150,000
$51,000
$51,000
$51,000
$51,000
$51,000
$99,000
$99,000
$99,000
$99,000
$99,000
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year
NWC
change in NWC
inflation
year
NWC
change in NWC
0
$200,000
-$200,000
1
$200,000
$0
2
$200,000
$0
3
$200,000
$0
4
$200,000
$0
5
$0
$200,000
2
$242,000
-$22,000
3
$266,200
-$24,200
4
$292,820
-$26,620
5
$0
$292,820
rate is 10%
0
$200,000
-$200,000
1
$220,000
-$20,000
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pro
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year
Revenue
COGS
Gross profit
Selling, general and
administrative expense
Depreciation
EBIT
Income tax @34%
Net Income
year
Net working capital
Fixed assets
Equity
0
$0
$0
$0
-$75,000
$0
-$75,000
-$25,500
-$49,500
Income Statement
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$100,000 -$100,000 -$100,000 -$100,000 -$100,000
$425,000 $425,000 $425,000 $425,000 $425,000
-$75,000
-$75,000
-$75,000
-$75,000
-$75,000
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4
$200,000
$200,000
$400,000
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5
$0
$0
$0
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year
incremental revenue
incremental cost
depreciation
EBIT
income tax @34%
incremental earnings
add: depreciation
subtract: Capex and
disposal of machine
subtract: change in
NWC
incremental free cash
flows
0
-$75,000
-$75,000
-$25,500
-$49,500
$0
1
2
3
4
5
$525,000 $525,000 $525,000 $525,000 $525,000
-$175,000 -$175,000 -$175,000 -$175,000 -$175,000
-$200,000 -$200,000 -$200,000 -$200,000 -$200,000
$150,000 $150,000 $150,000 $150,000 $150,000
$51,000
$51,000
$51,000
$51,000
$51,000
$99,000
$99,000
$99,000
$99,000
$99,000
$200,000 $200,000 $200,000 $200,000 $200,000
-$1,000,000
$0
$0
$0
$0
$33,000
-$200,000
$0
$0
$0
$0
$200,000
-$1,249,500
$299,000
$299,000
$299,000
$299,000
$532,000
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calculate
make
NPV
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Page 99
year
0
incremental free cash
-$1,249,500
flows
discounted cash flows
-$1,249,500
@12%
NPV
-$39,461
Decision
reject project
$299,000
$299,000
$299,000
$299,000
$532,000
$266,964
$238,361
$212,822
$190,020
$301,871
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Overall Example
You
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Overall Example
The
The
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Overall Example
year (HK$'000)
1. Initial investment of equipment
2. Accumulated depreciation
3. Year-end book value
4. Net working capital
5. Total book value (3+4)
6. Salvage value of equipment
7. Sales
8. Cost of goods sold
9. Other costs
10. Depreciation
11. Income before tax (7-8-9-10)
12. Tax at 16.5%
13. Net income (11-12)
0
12,000
12,000
550
12,550
4,000
-4,000
-660
-3,340
2,000
10,000
1,289
11,289
4,000
8,000
3,261
11,261
6,000
6,000
4,890
10,890
8,000
4,000
3,583
7,583
10,000
2,000
2,002
4,002
523
837
2,200
2,000
-4,514
-745
-3,769
12,887
7,729
1,210
2,000
1,948
321
1,627
32,610
19,552
1,331
2,000
9,727
1,605
8,122
48,901
29,345
1,464
2,000
16,092
2,655
13,437
35,834
21,492
1,611
2,000
10,731
1,771
8,960
12,000
0
0
0
2,000
19,717
11,830
1,772
2,000
6,115
1,009
5,106
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Overall Example
The
year (HK$'000)
1. Initial investment of equipment
2. Initial allowance of 60%
3. Annual allowance of 30%
4. Total tax depreciation
5. Year-end tax book value
0
12,000
7,200
1,440
8,640
3,360
1,008
1,008
2,352
706
706
1,646
494
494
1,152
346
346
807
242
242
565
Topic
Topic
053 Capital
Investment
Budgeting
Decision Rules and Capital Budgeting
M K Lai
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Page
Page
104
104
Overall Example
The
year (HK$'000)
1. Sales
2. Cost of goods sold
3. Other costs
4. Tax depreciation
5. Gain on sale of equipment
6. Taxable income
7. Tax at 16.5%
1
2
3
4
5
6
523 12,887 32,610 48,901 35,834 19,717
837
7,729 19,552 29,345 21,492 11,830
4,000
2,200
1,210
1,331
1,464
1,611
1,772
8,640
1,008
706
494
346
242
1,435
-4,000 -11,154
2,940 11,021 17,598 12,385
7,308
-660
-1,840
485
1,819
2,904
2,044
1,206
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Page 105
Overall Example
Assume
As
4,000
-660
-3,340
-550
-12,000
-15,890
-15,890
4,629
1
2
3
4
5
6
523 12,887 32,610 48,901 35,834 19,717
837
7,729 19,552 29,345 21,492 11,830
2,200
1,210
1,331
1,464
1,611
1,772
-1,840
485
1,819
2,904
2,044
1,206
-674
3,463
9,908 15,188 10,687
4,909
-739
-1,972
-1,629
1,307
1,581
2,002
2,000
-1,413
1,491
8,279 16,495 12,268
8,911
-1,177
1,035
4,791
7,955
4,930
2,984
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cost
incidental/externality/spillover/side
sunk
effects
cost (ignored)
overhead
financing
costs (excluded)
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Opportunity Cost
opportunity
cash
the
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Opportunity Cost
in
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Incidental/Externality/Spillover/
Side Effect
externality:
project
negative effects lead to cash outflows
erosion or cannibalization: cash flows of
new product come from those of old
products
environment: meeting environmental
standards
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Incidental/Externality/Spillover/
Side Effect
positive
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Sunk Cost
sunk
past
past
fixed
overhead expenses
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Financing Cost
financing
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Financing Cost
separation
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Post Audit
also
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Post Audit
uses
of post audit
1.
2.
3.
4.
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Page 119
Post Audit
feedback
financial
assumptions
statements and
market data
analysis
planning
current financial
pro-formas, cash
position and past
and capital
operating
budgets, financial
performance
plans
control
actual results
implementation of
financial plans
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Page 120
Conclusion
generate
be
project
use
carry
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Page 121
Challenging Questions
1. How is the NPV rule related to the goal of
maximizing shareholder wealth?
2. Why does the NPV decision not depend on the
investors preferences?
3. How can you interpret the difference between
the cost of capital and the internal rate of return
(IRR) under the NPV rule?
4. Explain why choosing the option with the highest
NPV is not always correct when the options have
different lives. What additional issues should
you keep in mind when choosing among
projects with different lives?
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Page 122
Challenging Questions
5. Which of the investment criteria in capital
budgeting does not take into account the project
risk, NPV, IRR, payback period, discounted
payback period and equivalent annual annuity?
6. What are the differences between incremental
earnings and incremental free cash flows in
capital budgeting?
7. Which of the following statements describes a
situation that is not considered as appropriate
when applying the net present value rule in
capital budgeting?
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Page 123
Challenging Questions
A. A financial manager estimates the beforetax cash flows of a project and discounts
them at the before-tax discount rate.
B. In considering two mutually exclusive
projects, a financial manager subtracts the
cash flows of one project from those of
another project. Based on the net present
value of this net cash flow stream, he makes
a decision to choose between these two
projects.
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Challenging Questions
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Challenging Questions
8. A company is considering whether to undertake a
project. In the project, the company is required to
make use of an idle machine which has no
alternative use at all. In the tax records, the net
book value of the machine is $100,000. In the
financial statements, the net book value of the
machine is $250,000. Which of the following
statements is correct with respect to the machine?
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Challenging Questions
A. There is no relevant cash flow associated
with the use of the machine in this project.
B. There is a relevant cash outflow of
$100,000 with the use of the machine in this
project because it is the opportunity cost.
C. There is a relevant cash outflow of
$150,000 with the use of the machine in this
project because it is the opportunity cost.
D. There is a relevant cash outflow of
$250,000 with the use of the machine in this
project because it is the opportunity cost.
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Challenging Questions
9. A company is carrying out a capital budgeting
exercise on an incremental project of project X
minus project Y. Which of the following items is
considered as a cash outflow for this
incremental project?
A. Project X will recognize an annual
depreciation expense of $200,000 for tax
reporting.
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Challenging Questions
B. In project X, it is estimated that some old
customers will switch from the old products
to the new products and there will be a drop
in the annual sales revenue of the old
products by $400,000.
C. There is an increase in net working capital
of $450,000 at the beginning of project Y.
D. There will be a tax saving on disposal of a
machine of $150,000 at the end of project Y.
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Challenging Questions
10.The board of directors of a company decides to
assign a particular senior manager in the
operations department to lead a new project of
improving the operational efficiency of the
company. In the capital budgeting exercise, the
board agrees that they should allocate the
salary of the senior manager as a cash outflow
to the project. The rationale is that the manager
is now 100% devoted to the project. Without the
project, he can be assigned elsewhere and this
is an opportunity cost. Do you agree?
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Challenging Questions
11. In order to fill the rush orders from customers, a
manufacturing company usually asks the workers
to work overtime, but the overtime pay is usually
1.1 times the normal pay on an hourly basis. With
a capital project, the company expects that there
will be a lot of rush orders from customers. In
order to give more incentives to the workers to
work overtime for the project, the company
decides to raise the overtime hourly wage rate to
1.15 times the normal hourly wage rate. Which of
the following statements is correct with respect to
the overtime pay for the project?
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Challenging Questions
A. The original overtime pay of 1.1 times the
normal pay for the project is relevant because it is
an incremental cash outflow.
B. The original overtime pay of 1.1 times the
normal pay for the project is irrelevant because it
is a sunk cost.
C. The additional overtime pay of 0.05 (1.15 1.1)
times the normal pay for the project is irrelevant
because it is a sunk cost.
D. The additional overtime pay of 0.05 (1.15 1.1)
times the normal pay for the project is relevant
because it is an incremental cash outflow.
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Challenging Questions
12.In the capital budgeting exercise on a project,
the chief financial officer of a company finds
that the company has the flexibility to give up
the project before the end of its life in the future.
Which of the following statements is correct in
respect of this flexibility to abandon?
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Challenging Questions
A. The flexibility may add negative value to the
net present value of the project because it
renders the initial investment of the project
worthless in the future.
B. The flexibility may add negative value to the
net present value of the project because of the
increased uncertainty.
C. The flexibility may add positive value to the
net present value of the project because it is
an opportunity cost.
D. The flexibility may add positive value to the
net present value of the project because it is a
strategic
option.
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