Professional Documents
Culture Documents
Enter your email address to follow this blog and receive notifications of new posts by email.
Follow
CFA INSTITUTE
ARCHIVES
CATEGORIES
Categories
10 TIPS FOR PASSING THE LEVEL I CHARTERED FINANCIAL ANALYST (CFA) EXAM
Today, we bring to you a guest post by Andrew Jones from Fitch Learning about very important tips that you need to
be aware of while preparing
DECEMBER LEVEL I RESULTS ARE OUT! CONGRATULATIONS TO 43% WHO PASSED AND SHORT POSTRESULTS SURVEY
The CFA institute has started emailing December 2013 CFA level I candidates with their exam results. The institute
has announced the pass rate to be
OVERVIEW OF DECEMBER (QUARTER PERFORMANCE): CFA LEVEL I EXAM AND DAILY CFA TRIVIA
As we mentioned in November, December and January are months in which no new readings are going to be posted.
Instead, we are going to
OVERVIEW OF NOVEMBER POSTS: TEXAS PLUS, COST OF CAPITAL, AND COMMON EXAM MISTAKES
THE LAST POST FOR THE YEAR
12,000 views This is where we stand today after five months of CFA fun. I am beyond happy with all the positive
feedback and
The material in this blog post is useful to the candidates preparing for: Level I of CFA Exams.
Today, we talk about an important topic that appears in corporate finance of level I which is the
criteria used for capital budgeting. That is, we talk about techniques used in deciding whether to
accept new projects or not: NPV, IRR, Payback, Discounted Payback, AAR.
Categories of Plans
1.
Replacement Projects: decisions to replace old equipment those are among the easier of
capital budgeting techniques. It is important to decide whether to replace the equipment when
it wears out or to invest in repairing the machine.
2.
Expansion Projects: These are decisions whether to increase the size of business or not
they are more uncertain than replacement projects.
3.
New products and services: These are decisions whether to introduce new products and
services or not they are more uncertain than both replacement and expansion projects.
4.
Safety and environmental projects: These are the projects required by governmental
agencies and insurance companies these projects might not generate revenue and are not
for profits; however, sometimes it is important to analyze the cash flows because the costs
might be very high that they require analysis.
2.
3.
Cash flows are based on opportunity cost: cash flows that occur with an investment
compared to what they would have been without the investment
4.
5.
Financing costs are ignored because they are incorporated in WACC that is why counting
them twice would be considered double counting
Sunk costs: costs that already incurred (i.e. paid for marketing research study) Today costs
should not be affected by sunk costs
2.
Opportunity costs: what a resource is worth for next-best use Those costs should be
considered (i.e. if you use a warehouse, the current market value should be considered)
3.
Incremental cash flow: the cash flow that is realized with the project that is, the cash flow
with a decision minus the cash flow without the decision
4.
Externality: the effect of an investment on other things apart from the investment. Those can
be positive or negative and should both be considered.
Conventional: Initial outflow followed by series of inflows (i.e. change of sign only occurs
once). That is, you can have + + + + + +, + + +, or + and still be considered
conventional cash flows because the sign changes only once.
Nonconventional: Initial outflow followed by series of inflows and outflows (i.e. change of
sign occurs more than once). Examples of those include + + + -, + + -, or + + +.
Independent projects: Cash flows are independent of each other. You can use both A and
B; there isnt overlap between projects. Projects here are being evaluated that could potentially
all be selected as long as their projected cash flows will produce a positive NPV or generate an
IRR greater than the firms hurdle rate.
Mutually exclusive projects: Projects that compete directly with each other (i.e. you own
some manufacturing equipment that must be replaced. Two different suppliers present a
purchase and installation plan for your consideration). Sometimes there are more than two
projects and you select one from group.
Unlimited funds: It assumes the company can raise funds for all profitable projects.
Capital rationing: It exists when a company has fixed amounts of funds to invest. If the
company has more project than funds, it must allocate the funds among the projects.
Project sequencing:
One last important concept here is project sequencing where many projects are evaluated
through time; that is, investing in one project gives the option to invest for other projects in the
future. For example, you can decide to open a mall this year and if the financial results are
favorable after 5 years, you will build a hotel next to the mall.
Does the decision rule adjust for the time value of money?
2.
3.
Does the decision rule provide information on whether we are creating value for the firm?
2.
Subtract the future cash flows from the initial cost until the initial investment has been
recovered
Decision Rule:
The decision rule is to accept if the payback period is less than some preset limit.
Pros and Cons:
Pros
Cons
1.
Easy to understand.
1.
2.
2.
3.
4.
Example:
Estimate the payback period for:
Year
CF
-10,000
4,500
4,500
3,000
2,000
Solution:
To find the payback period, we need to find the cumulative cash flows first
Year
CF
-10,000
4,500
4,500
3,000
2,000
CCF
-10000
-5500
-1000
2000
4000
The payback period occurs when the cumulative cash flows changes from negative to positive. That
is, it occurs between years 2 and 3. Because we still have to recover 1000 after second year, the
payback period is: 2 + 1000/3000 = 2.33 years.
2.
3.
Subtract the future discounted cash flows from the initial cost until the initial investment has
been recovered
Decision Rule:
The decision rule is to accept all projects with the discounted payback period less than a preset
limit.
Pros and Cons:
Pros
Cons
1.
2.
Easy to grasp.
3.
1.
If you discount values, then you might want to use NPV because
discounted payback wont be easier to analyze.
2.
3.
4.
5.
Example:
Estimate the discounted payback period at 10% discount rate for:
Year
CF
-10,000
4,500
4,500
3,000
2,000
Solution:
To find the discounted payback period, we need to find the cumulative discounted cash flows first:
Year
CF
-10,000
4,500
4,500
3,000
2,000
DCF
-10,000
4,090.91
3,719.01
2,253.94
1,366.03
CDCF
-10,000
-5,909.09
-2,190.08
63.86
1,429.89
The discounted payback period occurs when the cumulative discounted cash flows changes from
negative to positive. That is, it occurs between years 2 and 3. Because we still have to recover
2,190.08 after second year, the payback period is: 2 + 2190.08/2253.94 = 2.97 years.
Investment Decision Criteria: (3) Average Accounting Return
There are many different definitions for average accounting return. The most commonly used one is
the average net income to average book value. Note, however, that the average book value depends
on how the asset is depreciated.
Computation Method:
1.
2.
3.
4.
Estimate average book value (i.e. for straight-line depreciation, average book value is
[historical value salvage value]/2)
Decision Rule:
We accept the project if the AAR is greater than a preset rate.
Pros and Cons:
Pros
Cons
1.
Easy to calculate.
1.
2.
2.
3.
4.
Based on accounting net income and book values, not cash flows
and market values.
Example:
Assume a company invests 400,000 in project depreciated using straight-line method over 4 years
with zero salvage value. The following table shows the revenues and operating expenses. Calculate
AAR using 40% tax rate:
Year
Revenue
200,000
250,000
300,000
320,000
Operating Expenses
90,000
100,000
120,000
90,000
Solution:
First, we find the net income where depreciation = (book value salvage value)/ useful life.
Deprecation is 400,000/4 = 100,000
Year
Revenue
200,000
250,000
300,000
320,000
Operating Expenses
90,000
100,000
120,000
90,000
Depreciation
100,000
100,000
100,000
100,000
4,000
20,000
32,000
52,000
Net Income
6,000
30,000
48,000
78,000
2.
3.
Find the present value of the cash flows and subtract the initial investment.
1.
2.
Cons
1.
2.
3.
3.
4.
4.
Example:
Estimate the NPV at 10% discount rate for:
Year
CF
-10,000
4,500
4,500
3,000
2,000
Solution:
2.
3.
Find the present value of the cash flows and divide by the initial investment.
Where CFt is the cash flow at time t, r is the discount rate for the investment
and outlay is the investment cash flow at time 0.
Decision Rule:
We accept the project if the PI is greater than one. PI greater than one means that the project is
expected to add value to the firm and will therefore increase the wealth of the owners.
Pros and Cons:
Pros
Cons
1.
2.
1.
2.
Example:
Estimate the PI at 10% discount rate for:
Year
CF
-10,000
4,500
4,500
3,000
2,000
Solution:
2.
Estimate using trial and error the discount rate that makes NPV = 0
Decision Rule:
Accept the project if the IRR if it is greater than the required return.
Pros and Cons:
Pros
Cons
1.
2.
3.
1.
2.
Example:
Estimate the IRR at 10% discount rate for:
Year
CF
-10,000
4,500
4,500
3,000
2,000
Solution:
Using trial and error, if we start with discount rate of 17%
We find:
So we use a higher discount rate; lets say we apply a discount rate of18%, we find:
Therefore, the discount rate that makes NPV = 0 is between 17% and 18%. Keeping trial and error,
then IRR = 17.43%
IRR Alert
When using the IRR rule you have to be very careful from which standpoint you evaluate the
investment: investor or financier.
EXCEL FILE
This file can be used to solve problems related to capital budgeting techniques. In the first sheet, and
after entering conventional stream of cash flows for maximum of 15 periods, the file will solve for
payback period, discount payback period, NPV and IRR; it also shows the NPV profile. In the second
sheet, you can find average accounting return for a project given its estimated revenues, operating
expenses and book value.
Nonconventional cash flows cash flow signs change more than once
2.
Before showing the conflict between NPV and IRR, we must first discuss the concept of NPV profile
FINANCIAL
MANAGEME
NT
Solved
Problems
Rushi Ahuja1
SOLVED PROBLEMS CAPITAL BUDGETING
Problem 1
FINANCIAL MANAGEMENT
Solved Problems
Rushi Ahuja 2
ABC and Co. is considering a proposal to replace one of
its plants costing Rs. 60,000 and having awritten down
value of Rs. 24,000. The remaining economic life of the
plant is 4 years after which it willhave no salvage value.
However, if sold today, it has a salvage value of Rs.
20,000. The new machinecosting Rs. 1,30,000 is also
expected to have a life of 4 years with a scrap value of
Rs. 18,000. The newmachine, due to its technological
superiority, is expected to contribute additional annual
benefit (beforedepreciation and tax) of Rs. 60,000. Find
out the cash flows associated with this decision given
that thetax rate applicable to the firm is 40%. (The
capital gain or loss may be taken as not subject to tax).
Solution
(Amount in Rs.)
1. Initial cash outflow: 1,30,000Cost of new machine 2
0,000- Scrap value of old machine 1,10,0002. Subsequ
ent cash inflows (annual)Incremental benefit 60,000-
Incremental
depreciationDep. On new machine 28,000Dep. On old
machine 6,000 22,000Profit before tax 38,000- Tax
@ 40% 15,200Profit after tax 22,800+ Depreciation (
added back) 22,000Annual cash inflow 44,800The
amount of depreciation of Rs. 28,000 on the new
machine is ascertained as follows: (Rs. 1,30,000-Rs.
18,000)/4 = Rs. 28,000. It may be noted that in the
given situation, the benefits are given in theincremental
form i.e., the additional benefits contributed by the
proposal. Therefore, only the incrementaldepreciation
of Rs. 22,000 has been deduced to find out the
taxable profits. The same amount of depreciation
has been added back to find out the incremental annual
cash inflows.
Terminal cash inflow:
There will be an additional cash inflow of Rs. 18,000 at
the end of 4
th
year whenthe new machine will be scrapped away.
Therefore, total inflow of the last year would be Rs.
62,800 (i.e.Rs. 44,800 + Rs. 18,000).
Problem 4
XYZ is interested in assessing the cash flows associated
with the replacement of an old machine by a
newmachine. The old machine bought a few years ago
has a book value of Rs. 90,000 and it can be sold forRs.
90,000. It has a remaining life of five years after which
its salvage value is expected to be nil. It isbeing
depreciated annually at the rate of 20 per cent (written
FINANCIAL MANAGEMENT
Solved Problems
Rushi Ahuja 3Solution
Initial cash flows: Amt. (Rs.)
Cost of new machine 4,00,000- Salvage value of old m
achine 90,0003,10,000
Subsequent annual cash flows:(Amount Rs.
000)
Yr.1 Yr.2 Yr.3 Yr.4 Yr.5
Savings in costs (A) 100 100 100 100 100Depreciat
ion on new machine 133.3 88.9 59.3 39.5 26.3- De
preciation on old machine 18.0 14.4 11.5 9.2 7.4Th
erefore, incremental depreciation (B) 115.3 74.5 47
.8 30.3 18.9Net incremental saving (A B) -15.3 25
.5 52.2 69.7 81.1Less: Incremental Tax @ 50% -7.6
12.8 26.1 34.8 40.6Incremental Profit -7.7 12.7 26.
1 34.9 40.5Depreciation (added back) 115.3 74.5 4
FINANCIAL MANAGEMENT
Solved Problems