Final Analysis – Eiling
Note: The final is cumulative but for efficiency I will only explain concepts not covered in the midterm
Topic 1: Capital Budgeting
Capital budgeting is the process in which financial managers plan their capital (long-term) expenditures
(investments) and assess the appropriateness of these expenditures (investments) from associated
income and expenses. Don’t let the name scare you; capital budgeting is really no different from any
kind of budgeting in nature. If you have ever created any budget of any sort, you possess the mental
capacity to understand and perform capital budgeting. Now, you just have to learn the techniques used
in capital budgeting.
Net Present Value (NPV): a measure used to assess the appropriateness of capital expenditure.
It takes into account of all present and future cash flows (both inflows and outflows) associated
with a certain project, and discount the cash flows back to present time. If the net present value
is positive, then the project is profitable and we accept it. If NPV is negative, then we reject this
unprofitable project. When we choose between projects that are positive in NPV, we choose
the highest NPV project. It is the most preferred measure for evaluating appropriateness of
capital expenditures. One assumption is that the firm has the ability to reinvest cash flows at
the rate of return equivalent to cost of capital (similar to the idea of compound interest)
Internal Rate of Return (IRR): another measure with the same purpose as that of NPV. IRR is
the discount rate that makes NPV equal to 0. Its value indicates the rate of return that is offered
by the investment itself. Accept the project when the IRR is larger than your required rate of
return. Choose the highest IRR project if you have to choose only 1. IRR has the same
assumption as that in NPV, but with a few more disadvantages like possibility of multiple IRRs
and inability to distinguish between investments and borrowing.
Payback Period: a measure that determines in how many periods (usually years), you will
recover the cash outflow from initial investment. It is extremely simple to apply but it has many
disadvantages such as the negligence of time value of money and whatever that happens after
the payback period.
Discounted Payback Period: similar to Payback Period but takes into account of time value of
Profitability Index (PI): it equals [PV of total future cash flows / Initial Investment]. Minimum
acceptance criterion: accept if PI > 1. Ranking criterion: select the project with the highest PI.
Some disadvantages are that it is only a ratio but does not look at scalar effect.
Average Accounting Return (AAR): it equals [average net income/average book value of
investment]. Advantages: accounting information is usually available, easy to use. Disadvantages: ignores time value of money, based on book values but not cash flows and
Investment of unequal lives: a situation where the measurement of appropriateness can be
difficult. The project with the highest NPV might not be the true best project. In this case, there
are 2 methods we can use in order to standardize the evaluation process. 1) using the chain
replication rule: repeat projects until they end at the same time, then find the NPV. 2) using the
Equivalent Annuity NPV (EANPV): it calculates the annuity that gives the original NPV found in
each project. We then compare these 2 annuities and accept the one that’s larger. Examples
will be provided in the tutorial.
Professor Eiling’s slides include a lot of important formulas we will need to use to perform capital
budgeting. We need these formulas because in reality, we want to know the after-tax cash flows of a
given project. When tax becomes a factor, calculations derived from logic can be tedious and
troublesome. Therefore we will rely on formulas to help us to the answers faster. For the sake of
efficiency, I will not write these formulas here as they are in Professor Eiling’s slides anyway. Be sure to
look at her PowerPoint deck on Capital Budgeting and understand the calculation techniques and
formulas in detail.
Topic 2: Risk and Return Analysis
Risk and return analysis discusses the risk and return characteristics of investments. In general,
investments with more systematic, undiversifiable risk require higher returns to compensate for the
extra risk being borne. Systematic risk can be more easily understood as market risk; it is the risk that
the entire market is exposed to.