Bec 3 Financial Modeling For For Capital

Front 1

Capital Budgeting techniques

Back 1

Discounted Cash Flow
Payback period
Discounted Payback
NPV
IRR
Capital rationing
Profitability index

Front 2

Discounted Cash Flow

Back 2

Formula - none
Advantage- considers time value of money
Limitation- assumes simple constant growth ie single interest rate assumption

Front 3

Payback period

Back 3

Net initial investment / Increase in annual net after - tax cash flow

Advantages-
easy to use
emphasis on liquidity
Limitations-
- time value of money ignored
- cash flows after investment recovery not considered
-total project profitability and reinvestment not considered.

Front 4

Bailout payback period

Back 4

Includes salvage value in numerator
and therefore shortens payback period

Front 5

Discounted Payback

Back 5

also called break even time method or BET

Front 6

Net present value

Back 6

= the PV of an investment's future net cash flows minus the initial investment.
-it assumes that positive cash flows are reinvested at the hurdle rate ( rate used in the analysis) thereby considering compounding of returns

Accept -when NPV > 0
- then IRR<hurdle rate (RRR)
Reject - when NPV< 0- then IRR > RRR (hurdle rate)
Advantages-
-flexible, more than one rate of interest
- considered best method
Limitation
- does not give the true rate of return, just indicates if investment will earn hurdle rate
-
-

Front 7

4 steps to calculate NPV

Back 7

1. Compute after tax cash flow= Pre-tax cash flow x (1- tax rate)
2. Add depreciation benefit = Depreciation x tax rate
3. Multiply result by appropriate present value of annuity.
4 Subtract initial Cash outflow
(Investment)

Front 8

Internal rate of return
OR
Time adjusted rate of return

Back 8

determines present value factor that yields an NPV = 0

when IRR>hurdle (targeted RRR) rate
Regect when IRR< or = hurdle (targeted) rate
IRR> RRR when NPV =0

Limitations-
- unreasonable reinvestment assumption at IRR rate
-considers uniform cash flow
-does consider amount of profit

Front 9

NPV vs IRR methods

Back 9

NPV - highlights amounts, more conservative, assumes reinvestment @ hurdle rate
IRR - focuses decision makers on %, more aggressive, assumes reinvestment @ IRR, less reliable.

NPV is superior to IRR as it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of return for each year of the project.

Front 10

Profitability index =

Back 10

(PV of cash flows) / Initial investment

If Profitability index > 1 then NPV > 0
It provides the means to rank capital projects w/ different amounts of investment