14.1: General Guidelines for Capital Expenditure Analysis Flashcards
What should be the basis for estimating all cash flows in capital budgeting?
All cash flows should be estimated on an after-tax basis because taxes can play an important role in any investment decision.
We use an after-tax cost of capital to discount these cash flows, comparing like with like using an after-tax discount rate.
What are marginal or incremental cash flows?
Marginal or incremental cash flows are the additional cash flows that result from capital budgeting decisions, including changes in existing flows from the firm’s decisions.
For example, if introducing a new product results in additional after-tax cash flows of $100,000 per year but causes a loss of $40,000 in after-tax cash flows from an existing product, the marginal cash flow is $60,000 per year ($100,000 - $40,000).
Why should associated interest and dividend payments not be included in estimated project cash flows?
Associated interest and dividend payments should not be included because they are already accounted for in the discount rate, which captures all financing costs.
The weighted average cost of capital (WACC) is used for this purpose.
How should working capital adjustments be handled in cash flow estimates?
Cash flows should be adjusted to reflect any additional working capital requirements.
This includes the initial cash outlay and the terminal cash flow at the end of the project’s life.
For example, a project might require holding more inventory, tying up more funds. This drain on cash should be included in the budgeting decision.
Any initial working capital is typically reversed at the end of a project’s life, and the present value of these changes should not generally net to zero.
What are sunk costs and how should they be treated in capital budgeting decisions?
Sunk costs are costs that have already been incurred, cannot be recovered, and should not influence current capital budgeting decisions. They should be ignored in the analysis.
What are opportunity costs and how should they be factored into cash flow estimates?
Opportunity costs represent cash flows that must be forgone as the result of an investment decision.
For instance, if a firm purchased land for $150,000 and can now sell it for $200,000, the $200,000 is the opportunity cost of using the land for a project and should be included in the cost.
How should the appropriate time horizon for the project be determined?
The appropriate time horizon should be determined based on how long the project is likely to continue before it is economical to finish or replace it.
“Abandonment decisions” must be considered, as projects should be evaluated on the duration that makes economic sense, not based on the engineer’s assessment of asset functionality.
How should intangible considerations be handled in financial analysis?
Intangible considerations should be ignored unless their impact on cash flows can be estimated.
Intangible benefits are often used to justify poor projects, and if there are spinoffs, they should be analyzed and incorporated into the financial analysis.
What are externalities and how should they be treated in cash flow estimates?
Externalities are the consequences of an investment that may benefit or harm unrelated third parties.
Though not accounted for in the financial analysis, they can have a significant impact on the investment decision.
How should project interdependencies be considered in cash flow estimates?
Project interdependencies should be considered as they can affect the overall analysis.
For example, a project with a negative NPV might give the firm the option to undertake more valuable projects in the future.
Why is it important to treat inflation consistently in capital budgeting decisions?
Inflation must be treated consistently by comparing like with like:
nominal cash flows should be discounted with nominal discount rates,
and real cash flows with real discount rates.
This consistency ensures accurate valuation.
How should social investments required by law be considered in capital budgeting?
Social investments required by law should be undertaken even if they have negative rates of return or no definable impact on the value of the firm, as compliance is mandatory.
What are the definitions of marginal or incremental cash flows, sunk costs, opportunity costs, and externalities?
Marginal or incremental cash flows: Additional cash flows from capital budgeting decisions.
Sunk costs: Costs that have already been incurred and cannot be recovered.
Opportunity costs: Cash flows that must be forgone due to an investment decision.
Externalities: Consequences of an investment that may benefit or harm unrelated third parties.
