1. Capital Budgeting Flashcards
How to calculate ‘After-tax operating cash flows (CF)’?
CF = (Sales - Costs - Depreciation)(1-t) + D or CF = (S-C)(1-t) + (tD)
How to calculate ‘terminal year after-tax-non-operating cash flows’ (TNOCF)?
TNOCF = (Pre-tax cash proceeds from sale of fixed capital) - t*(Pre-tax cash proceeds from sale of fixed capital - Book value of the fixed capital sold)
When two projects are mutually exclusive, the firm may choose one projct or the other, but not both. If mutually exclusive projects have different lives, and the projects are expected to be replaced indefinetely as they wear out, an adjustment needs to be made in the decision-making process. Explain the methods you can use to make this adjustment.
- Least common multiple of lives approach
Use o minimo multiplo comum para a duração dos projetos - Equivalent annual annuity (EAA) approach
Find each project’s NPV
Find an annuity (EAA) with a present value equal to the project’s NPV over its individual life at the WACC (ache o PMT)
Select the project with the highest PMT.
Explain capital rationing, hard capital rationing and soft capital rationing.
Capital rationing is the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth.
Hard capital rationing occurs when the funds allocated to managers under the capital budget cannot be increased.
Soft capital rationing occurs when managers are allowed to increase their allocated capital budget if they can justify to senior management that the additional funds will create shareholder value.
Explain hurdle rate in the context of capital budgeting.
Using a project’s beta to determine discount rates is important when the risk of a project is different from the risk of the overall company. Such a project-specific discount rate is also called a hurdle rate. Hurdle rates vary from project to project. Simply using the comprany’s WACC will overstate the required return for a conservative (low beta) project and will understate the required return for an aggressive (high beta) project.
Explain ‘economic income’ and ‘accounting income’.
1) Accounting and economic income measures are alternatives to the basic discounted incremental cash flow approach used in the standard capital budgeting.
Economic Income = Cash Flow + (ending market value - beginning market value)
= Cash Flow - Economic Depreciation
2) Accounting Income is the reported net income on a company’s financial statements. Difere do ‘basic’ pq interest entra no income e nao somente no wacc.
Why the accounting income differs from the economic income? Two reasons.
1) Accounting depreceiation is based on the original cost of the investment, while economic depreciation (Beginning - Ending Value) is based on the market value of the asset. The economic depreciation for the project is much larger than the accounting depreciation, resulting in an economic income amount that is much smaller than accounting income.
2) Interest expense is deducted from the accounting income figure. Interest expense is ignored when computing economic income because it is reflected in the WACC.
Explain and show how to calculate ‘economic profit’.
Economic profit is a measure of profit in excess of the dollar cost of capital invested in a project.
Economic Profit = NOPAT - $WACC
NOPAT = EBIT*(1-t)
$WACC = WACC x Amortized Capital Invested
The valuation using economic profit is the same as the valuation using the basic NPV approach. No matter which method is used for determining income, if it is applied correctly, the resulting NPV should be the same.
Explain and show how to calculate ‘market value added (MVA)’.
Market value added is the NPV based on economic profit. Once the economic profit (=NOPAT-$WACC) is determined, it is easily applied to the valuation of on asset.
The valuation using economic profit is the same as the valuation using the basic NPV approach. No matter which method is used for determining income, if it is applied correctly, the resulting NPV should be the same.
How to calculate the ‘company value’ based in the NPV of the project?
The value of the company is the NPV of the project plus the initial investment.
Explain and show how to calculate ‘Residual Income’.
Residual income focuses on returns on equity and is determined by subtracting an equity charge from the accounting net income. The equity charge is found by multiplying the required return on equity by the beginning book value of equity.
Residual Income = Net Income - Equity Charge
Discounting the residual income at the required rate of return on equity will give the NPV of the investment.
The residual income approach focuses only on returns to equityholders; therefore, the appropriate discount rate is the required return on equity.
Whether the economic profit, residual income, or claims valuation method for determining income is used, the key is that in theory, any of the theree methods should result in the same value for the company.
True or false?
True.
Which are the main kinds of real options in capital budgeting?
Timing options: allow a company to delay making an investment
Abandonment options: allow management to abandon a project if the PV of the incremental CFs from exiting a project exceeds the PV value of the incremental CFs from continuing a project
Expansion options: allow a company to make additional investments in a project if doing so creates value
Flexibility options: give managers choices regarding the operational aspects of a project
Fundamental options: are projects that are options themselves because the payoffs depend on the price of an underlying asset. For example, the payoff for a copper mine is dependent on the market price for copper. If copper prices are low, it may not make sense to open a copper mine. The operator has the option to close the mine when prices are low and open it when prices are high.
