Finance Textbook Notes – Chapter 9: Special Issues In Capital Budgeting Decisions

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Notes from various chapters in the core finance textbook, Financial Management, Concepts and Applications by Ramesh K.S. Rao.
Source: Financial Management, Concepts and Applications by Ramesh K.S. Rao
Subject: Finance
  1. To create an NPV profile, one needs only the stream of cash flows that comprise the project. From this, different NPVs can be run at RRRs between 0 and the IRR and each NPV can be plotted into a profile.
  2. The IRR is the point on the NPV profile where the NPV line crosses the X-axis (i.e. where the NPV = 0).
  3. Conventional projects have a negative initial cash outflow and then a series of cash inflows through the life of the project (or vice-versa). A non-conventional project has cash flows that may vary (inflows, outflows) from period to period during the life of the project (i.e. multiple sign changes can occur). The significance of this is that conventional projects have only one IRR (one sign change), while non-conventional projects can have none or many IRRs (one per sign change). This make the analysis of a non-conventional cash flow somewhat more complicated than a conventional.
  4. When a project has more than one IRR, they are all correct. Therefore you must look to the NPV criterion.
  5. A project might have no IRR if there is a large initial cash inflow as opposed to a capital outlay.
  6. An accept/reject decision is merely assessing whether or not to accept/reject a project based on its NPV and/or IRR (depending on criterion used). Several projects, if they all have positive NPVs, should all be “accepted” by management (ignoring all other constraints). Ranking involves comparing two or more mutually exclusive projects that are both “acceptable” (i.e. both earn excess returns) to determine which investments are the most valuable. Whenever two or more projects must be ranked because they are mutually exclusive, the rankings based on their IRRs may differ from their rankings based on the NPVs. This difference is based on the RRR used in the calculation, and within certain ranges of RRR, the ranking may yield a different decision based on the relative slope of the NPV profile. The best answer is to always use the NPV criterion, which is always consistent with value maximization.
  7. There are also ranking conflicts when using NPV vs. PI, even though they are based on the same inputs. This is because the PI is a relative measure and does not consider the size of the cash flows. Once again, the NPV is preferable.
  8. When mutually exclusive projects with unequal lives are encountered, once must “standardize” the lives of both projects to make them comparable. Without doing so, the projects cannot be ranked correctly because they do not consider the same discount period.
  9. The UAS method is a much simpler calculation than the replacement chain method, especially when the comparative years are unusual and the common life is excessive.
  10. Some common reasons for capital rationing are (1) to constrain organizational unit growth, (2) to constrain a firm’s overall growth, and (3) to constrain financing to internally generated funds (debt-averse).
  11. When faced with multiple indivisible independent projects, a manager should choose that combination of projects that yields the largest aggregate NPV within the boundaries of the capital constraint.
  12. The PI criterion is best suited for ranking divisible projects with capital constraints because the object with divisible projects is to maximize the increment in wealth per dollar invested (which will be up to the capital constraint). This is exactly what the PI measures.
  13. One might want to dispose of an asset before the end of a project’s life if doing so would generate a larger NPV than not doing so.
  14. To determine the optimal time to replace an asset, one must make an assumption about the market value of the asset at the end of each year in its life and then calculate a UAS for each possible life. The year with the largest UAS is the optimal year to replace the asset.
  15. The market value of the asset at the end of each year is difficult to know.
  16. Firms want to compete in a global market to capitalize on the competitive advantages that exist in the global economy (that may or may not be available domestically).
  17. Political risk generally takes the form of country-specific risks or firm-specific risks. Country-specific risks, like bribes, affect every competitor in the country (foreign or domestic). Firm-specific risks, like special taxes or regulations on foreign companies operating in the country, only impact foreign firms. This political risk can be managed by cleverly designing alliances between foreign companies operating within that country, or by hiring local employees and encouraging local investment. Firms can also purchase political risk insurance.
  18. A spot exchange rate is the current exchange rate between two currencies. A forward exchange rate is an agreement to buy/sell currency at a certain exchange rate some date in the near future. It is nothing more than the strike price of a futures contract.
  19. In general, one must be cautious when figuring incremental cash flows from an international source. This is because many times there are special arrangements, like supervisory fees, royalties, and tie-in sales that arise for various reasons in international settings. This make the identification of incremental cash flows more complicated. Also, when determining a discount rate, the international markets are not the domestic markets. Care should be taken when establishing a discount rate and one should not simple adjust the rate upward to account for risk. Market inefficiency in a particular country may in fact result in a lower discount rate. The overriding point is that there are more issues and considerations when dealing with global companies and international cash flows and extra care should be taken when analyzing global projects.

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