Cfa Note 4 Highlight

CFA note 4

Capital budgeting process(p1):identify and evaluate capital projects  (impact on future earnings)[pic 1]

                                   Cash flow to the firm that will receive over one year

                Eg. Buy a new machine, expand business in another area, move headquarters

         Financial manager primary goal: maximize shareholder value

       Four step: 

1. Idea generation
2. Analyzing project proposals
3. Create the firm-wide capital budget
4. Monitoring decisions and conducting a post-audit

                 Categories of capital budgeting

1. Replacement projects to maintain the business
2. Replacement projects for cost reduction
3. Expansion projects
4. New product or market development
5. Mandatory projects

Five principles

1. Decision based on cash flows, not accounting income (incremental)

Sunk costs: costs cannot be avoid, not included in the analysis

Externalities: accept one project may have other firm cash flows

                        A negative one called cannibalization: 减去old line的existing sales

                        Positive: positive effect on other product line

1. Cash flow based on opportunity cost (should be include)
2. The timing of cash flows is important

Cash receive now worth more than receive later

1. Cash flow analyzed on an after-tax basis
2. Financial costs are reflected in the project’s required rate of return

Expected return > cost of capital→ increase the value of the firm

Independent projects: can accept project A and B

Mutually exclusive projects: only accept project A or B

Project Sequencing: 次序

Unlimited funds and capital rationing

Company have constrains on the amount of capital they raise

NPV&IRR

Discount rate: firm’s cost of capital

NPV=present value of the expected inflows-initial cost of the project

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 Internal Rate of Return (IRR)

     Discount rate that makes the PV of the expected incremental after tax cash inflows equal to the initial cost of the project.

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the shorter, the better

Drawback 1) not consider the time value of money

2) Cash flows beyond the payback period (terminal/salvage value not consider

        Benefit   good measure of liquidity

Discount Payback period