Capital Budgeting Flashcards
What cash flows are considered in capital budgeting analysis- those that will only occur or not occur if the project is accepted.
Relevant cash flows
What are relevant Chas flows defines in
Terms of change in or incremental to the first existing cash flow, they are called incremental cash flows
Cash flows are defined in terms of
Terms of change in or incremental to the first existing cash flow, they are called incremental cash flows
Stand alone principal
allows us to analyze each project in isolation from the firm simply, by focusing on incremental cash flows
Terminal value of the project
Present value at a future point in time of all future cash flows when we expect stable growth rate forever
You should always ask yourself “ will this CF occur ONLY if we accept this project”
– If the answer is “yes”, it should be included in the analysis because it is incremental
– If the answer is “no”, it should not be included in the analysis because it will occur anyway
– If the answer is “part of it”, then we should include the part that occurs (or does not occur) because of the project
Sunk costs
A sunk cost is a cost we have already paid or have already incurred the liability to pay.
In finance we only consider the future cash flows that are within our control
The book value of assets is irrelevant in capital budgeting
Opportunity costs
An opportunity cost is something we give up to do something else.
For example, if we paid (at some point in the past) $25,000 for a building that is currently not being used and which has a current market value of $20,000, the opportunity cost of using the building versus selling it is $20,000 (not $25,000).
i.e.: we had the opportunity to sell the building. We decided not to take that opportunity, which had a value of $20,000, hence our opportunity cost is $20,000. Our purchase price for the building is ‹# irrelevant in considering the value of a foregone opportunity
Side effects (relevant)
It is not unusual for a project to have side, or spillover, effects, both good and bad.
For example, when Apple introduced the 2nd, 3rd, 4th, and mini generation iPads, what do you think happened to sales of the 1st generation iPad? What about iPad Mini? Did cannibalization occur?.
On the other hand, if Apple introduces new accessories or apps to go with a current model, sales of the accessories and the unit may both increase.
Net working capital (relevant)
Most projects need an investment in NWC (cash on hand, inventories, and accounts receivable minus accounts payable).
Investment projects generally have a cash outflow for NWC at the beginning of a project and a cash inflow from NWC at the end of the project
Financing costs (irrelevant)
Irrelevant in capital budgeting
Financing for a project is a capital structure decision, and the type of financing is irrelevant to the accept-reject decision in capital budgeting.
For example, a firm can use only equity and have no interest charges or it can finance using only debt and incur interest charges.
Inflation (relevant)
Since discount rates include an adjustment for inflation, cash flow estimates must also be adjusted for inflation.
Using an inflation adjusted discount rate while ignoring
inflation in estimating cash flows would result in a bias against accepting projects
What does capital budgeting rely on
heavily on pro forma accounting statements, particularly income statements
Why do we have to consider change in NWC separately
– GAAP requires that sales be recorded on the statement of comprehensive income when made, not when cash is received
– GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet
• •
– Finally, we have to buy inventory to support sales although we haven’t collected cash yet
Capital Cost Allowance
CCAisdepreciationfortaxpurposes
• The depreciation expense used for capital budgeting should be calculated according to the CCA schedule dictated by the tax code
• Depreciation itself is a non-cash expense, consequently, it is only relevant because it affects taxes
Bottom up approach
Works only when there is no interest expense Operating cash flow (OCF) = NI + Depreciation OCF=(S-C-D)(1-Tc)+D
Equivalent annual cost
Annual cost of owning and maintaining an asset over its entire life
The present value of a project’s costs calculated on an annual basis.
We are interested in incremental cash flows or
cost savings
