Capital Budgeting

Question 0

What is included in initial investment outlay

Answer 0

Purchase price
Transportation cost
Installation cost 
Additional training cost 
Increase in net working capital

Question 1

What are three calculations needed for expansion and replacement projects

Answer 1

Initial outlay
Annual incremental after tax cash flows
Terminal cash flows

Question 2

How to calc after tax op cf

Answer 2

CF = (S - C - D)(1 - T) + D

= (sales - cash op costs)(1-tax) + (tax*dep exp)

Question 3

Terminal year after tax non operating cash flow (TNOCF)

Answer 3

TNOCF = SalT + NWCInv - T(SalT - Bt)

Question 4

What is difference between initial outlay for replacement project vs. expansion project?

Answer 4

Replacement project must reduce initial outlay by after tax proceeds of sale of existing asset
Use change in depreciation resulting from replacement

Question 5

What are three decision rules to accept project

Answer 5

Positive NPV or IRR> project cost of capital or PI > 1

Expected life equal to remaining life of equipment (otherwise requires adjustment)

Question 6

What are tax implications of sale of assets

Answer 6

Change in cash flow:

• decreases if sale price > BV; tax paid on gain
• increases if sale price < BV; tax reduction

Question 7

What is included and excluded from after tax cash flows?

Answer 7

Include: opp cost of existing assets, shipping/install costs, externalities
Exclude: sunk costs, financing costs

Question 8

What to do if project has different life

Answer 8

Use one of:
- replacement chain approach
- equivalent annual annuity approach
To calc the equivalent NPV/IRR

Question 9

How to do replacement chain approach

Answer 9

1. Repeat shorter project until number of years equals longer
2. Compare NPV of two projects with equal time periods
3. Accept greatest NPV (if +)

Question 10

How to calc equivalent annual annuity

Answer 10

1. Take NPV, FV, N, I/Y (WACC) and compute payment for each project
2. Compare PMT
3. Accept larger payment

Question 11

What are three techniques for estimating stand-alone risk of capital investment?

Answer 11

Sensitivity analysis
Scenario analysis
Monte Carlo simulation

Question 12

How to do sensitivity analysis

Answer 12

1. Change one variable
2. Recalculate NPV for both projects
3. Compare change in NPV
4. Greater change for given variable change is riskier project

Question 13

How to so scenario analysis

Answer 13

1. Calculate NPV for base case, worst case, best case
2. Assign probability to each outcome
3. Calculate standard deviation of NPV

Question 14

How to calc Monte Carlo simulation

Answer 14

1. Assume probability distributions for key variables in NPV
2. Draw random values for variables and calc NPV
3. Repeat x1000s
4. Use distribution of NPV to estimate expected NPV and stand dev

Question 15

Capital rationing is necessary when…

Answer 15

Firms have insufficient funds to invest in positive NPV projects until marginal returns = cost of capital

Question 16

Explain capital rationing

Answer 16

Allocating available funds to the set of projects with the greatest NPV

Question 17

How to use CAPM to determine appropriate discount rate for project

Answer 17

Rproject = Rf + Bproject(E(Rm) - Rf)

Question 18

What are real options

Answer 18

Based on assets, right but not obligation; allow mgr flexibility to increase NPV of individual project

Ex. Timing, abandonment, expansion, price setting/production, fundamental options

Question 19

How to evaluate profitability of real options

Answer 19

1. Calc NPV w/out option; if >0, proceed
2. Calc NPV + est value of option
3. Use decision tree
4. Use option pricing model

Question 20

What is economic income

Answer 20

Economic income = after tax CF - economic depreciation

Ec dep = beg mkt value - end mkt value

Question 21

What is accounting income

Answer 21

Reported net income on fin statements resulting from investment in project

Question 22

What is diff between accounting and economic income

Answer 22

1. Accounting dep based on original investment vs. economic dep on change in mkt value of investment
2. Accounting: after tax cost of debt is subtracted vs. econ: reflected in discount rate

Question 23

What is economic profit

Answer 23

NOPAT - $WACC

Question 24

What is residual income

Answer 24

Returns to equity holders

= net income - equity charge

Question 25

What is claims valuation

Answer 25

= PV (equity holder CFs) + PV (debt holder CFs)

Discounted at cost of equity and debt respectively

Question 26

Average accounting return

Answer 26

Average book value

Question 27

Profitability index (PI)

Answer 27

Initial investment

= 1+NPV/initial investment

Question 28

Calc initial outlay

Answer 28

Outlay = FCInv + NWCInv - Sal0 + T(Sal0-B0)

Question 29

Market value added

Answer 29

Sum (Econ profit)
————
(1+WACC)^t
= NPV