3.2. Fundamentals of Capital Budgeting Flashcards
What is a capital budget(ing)? + Goal
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- it lists the projects and investments that a company plans to undertake during the coming year
- to determine this list, firms analyze alternative projects and decise which one to accept through a processed called capital budgeting
- ultimate gol: determine the effect of the decision on the firms cash flows, and evaluate the NPV of these cash flows to access the consequences of the decision for the firms value ((earnings are NOT actual cash flows!))
What does Forecasting Earnings Mean?
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- financial managers forecast earnings in order to derive the forecasted cash flow of a project
- beginning by: determining the incremental earnings of a project, that is, the amount by which the firms earnings are expected to change as a result of the investment decision
What are Incremental Earnings?
the amount by which the firms earnings are expected to change as a result of the investment decision
What is the striaght line depreciation?
simplest method used to compute depreciation, in which the assets cost is divided equally over its estimated life
- When evaluating a capital budgeting decision, we generally do not include…
- Any incremental interest expense will be related to the firms decision regarding…
- We refer to the ….. as the unlevered net income of the project, to indicate that it does not include any interest expenses associated with debt
- …. interest expenses
- …. how to finance the project
- net income we compute
- The correct tax to use is the…
- which is the tax rate that…
- …. firms marginal corporate tax rate
- will pay on an incremental dollar of pre-tax income
Tax payments cannot be…
…. negative
In the event of a loss in the project, the tax can be…
since….
fictitiously positively attributed, since the loss reduces the tax burden from other activities from the company.
If a company has no other taxable profit, the project loss can be…
…. carried forward to the next year and offset against future profits
(balance sheet: deferred tax asset)
What are Opportunity Costs in terms of resources?
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- The opportunity costs of using a resource is the value it could have provided inits best alternative use
- this value is lost when the resource is used by another project -> we should include the o.c. as an incremental cost of the project
What are Project Externailities?
indirect effects of the project that may increase or decrease the profits of other business activities of the firm
What is cannibalization?
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- in relation to project externalities
- when sales of a new product displace sales of an existing product, the situation is often referred to as this
What is a sunk cost? + Examples
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- any unrecoverable cost for which the firm is already liable
- has been paid or will be paid regardless of the decision about whether or not to proceed with the project
- good rule: “if our decision does not affect the cash flow, then the cash flow should not affect our decision”
- e.g. fixed overhead expenses, past research, development expenditures, unavoidable competitive effects
Why is the Real World so much more complex?
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- estimates of the revenues and costs much more complicated
- new product typically has lower sales initially (customers gradually become aware of product)
- sales then: accelerate -> plateau -> decline when product nears obsolescence or faces increased competition
- average selling price + cost production of product always changes (e.g. rising with inflation)
- technology prices often fall though
- most industries: competition tends to reduce profit margins over time
What does a firm need cash for and not earnings?
cash for buying goods, pay employees, fundings
earnings -> accounting measure of a firms performance
