Capital Budgeting Techniques Mind Map
2024-09-04 17:46:48 0 Report
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Outline/Content
Difference between the present value of cash inflows and outflows
Concept of NPV
Future cash flows are discounted to present value
Reflects Time Value of Money
Definition
Formula: NPV = Σ (Cash Flow / (1 + Discount Rate)^t) - Initial Investment
Example Calculation
Calculation
Shows value created for the firm
Direct Measure of Added Value
Provides a realistic measure of profitability
Considers Time Value of Money
Advantages
Dependent on cash flow estimates
Requires Accurate Forecasting
Small changes in rate can affect NPV significantly
Sensitive to Discount Rate Assumptions
Disadvantages
Net Present Value (NPV)
Discount rate that makes NPV of cash flows zero
Concept of IRR
IRR should exceed the cost of capital to be acceptable
Comparison with Cost of Capital
Iterative process or financial calculator/software
Finding the Discount Rate that Sets NPV to Zero
Percentage return is intuitive
Easy to Understand and Communicate
Simple comparison of different projects' returns
Useful for Comparing Projects
Multiple IRRs can occur with alternating cash flows
Can Be Misleading with Non-Conventional Cash Flows
Not unique in certain scenarios
Multiple IRRs in Some Cases
Internal Rate of Return (IRR)
Time required to recoup the initial investment
Concept of Payback Period
Measures how quickly the investment can be recovered
Focus on Liquidity
Formula: Payback Period = Initial Investment / Annual Cash Inflows
Straightforward and easy to use
Simple to Calculate and Understand
Quick assessment of how soon the investment is recovered
Measures Liquidity Risk
Does not discount future cash flows
Ignores Time Value of Money
Does Not Measure Profitability
Payback Period
Time required to recoup the initial investment using discounted cash flows
Concept of Discounted Payback Period
Discounts future cash flows to present value
Incorporates Time Value of Money
Uses discounted cash flows to calculate payback period
Adjusting Payback Calculation with Discounted Cash Flows
Accounts for time value of money
More Accurate than Payback Period
Provides a more realistic recovery time
Does not consider profitability after the payback period
Still Ignores Cash Flows Beyond Payback Period
Discounted Payback Period
Ratio of the present value of cash inflows to the initial investment
Concept of PI
Indicates relative profitability of an investment
Ratio of Present Value of Cash Inflows to Outflows
Formula: PI = Present Value of Cash Inflows / Initial Investment
Relative measure of profitability
Useful for Comparing Projects of Different Sizes
Helps prioritize projects with higher PI
Indicates Relative Profitability
May not provide a clear decision if projects are competing for the same resources
Less Useful for Mutually Exclusive Projects
Profitability Index (PI)
Adjusts IRR to account for cost of capital and reinvestment rates
Concept of MIRR
Provides a more accurate reflection of profitability
Adjustments to IRR Calculation
Formula: MIRR = (Terminal Value of Cash Inflows / PV of Cash Outflows)^(1/n) - 1
Corrects for unrealistic IRR assumptions
Addresses Some IRR Limitations
Reflects true profitability more accurately
Provides a More Accurate Measure
Requires additional calculations compared to IRR
More Complex to Calculate
Modified Internal Rate of Return (MIRR)
Techniques for Capital Budgeting
Process of planning and managing investments in fixed assets
Evaluates potential major projects or investments
What is Capital Budgeting?
Determines which projects to pursue
Ensures effective allocation of resources
Purpose and Importance
Increasing shareholder wealth
Long-term financial growth
Maximizing Firm Value
Prioritizing profitable projects
Managing risk and returns
Allocating Resources Efficiently
Objectives
Introduction to Capital Budgeting
NPV as a Dollar Amount vs. IRR as a Percentage
NPV: Accept if positive; IRR: Accept if IRR > Cost of Capital
Decision Criteria Differences
Differences
Best for determining the exact value added
NPV for Absolute Value
Useful for comparing projects of different scales
IRR for Percentage-Based Comparison
When to Use Each
NPV vs. IRR
Discounted Payback accounts for time value of money
Payback Period vs. Discounted Adjustments
Payback Period ignores future cash flows beyond recovery; Discounted Payback considers discounted cash flows
Cash Flow Consideration Differences
Payback Period vs. Discounted Payback Period
Comparing Techniques
Assessing feasibility and profitability of new investments
Evaluating New Projects
Deciding whether to replace or upgrade existing assets
Asset Replacement
Investment Decisions
Analyzing how changes in key assumptions impact outcomes
Sensitivity Analysis
Evaluating different scenarios and their impact on project viability
Scenario Analysis
Risk Assessment
Applications of Capital Budgeting
Techniques for Improving Accuracy
Accuracy of Projections
Assessing impact of uncertainties on cash flows
Using Sensitivity and Scenario Analysis
Handling Uncertainties
Estimating Cash Flows
Techniques for Determining Appropriate Rate
Choosing the Right Rate
Evaluating how variations in rate affect NPV and other metrics
Sensitivity to Discount Rate Changes
Impact on Results
Discount Rate Selection
Common Challenges and Solutions
Capital Budgeting Techniques Mind Map
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