Capital Budgeting

Question 1

Depreciable Basis

Answer 1

depreciable basis = purchase price + shipping, handling, and installation costs

Question 2

Three Types of Incremental Cash Flows

Answer 2

(1) Initial investment outlay
(2) Operating cash flow over project’s life
(3) Terminal-year cash flow

Question 3

Initial Investment Outlay

Answer 3

Upfront costs associated with the project

outlay = FcInv + NWCInv

Question 4

NWCInv

Answer 4

NWCInv = change in non-cash current asets - change in non-cash current liabilities

positive = requires cash = outflow

negative = frees up cash = inflow

Question 5

After-tax operating cash flows (CF)

Answer 5

add deprecation back to net income:
CF = ( S - C - D ) ( 1 - T ) + D

adding the tax savings caused by depreciation back to after-tax gross profit:
CF = ( S - C ) ( 1 - T ) + ( TD )

Question 6

Terminal year after-tax non-operating cash flows (TNOCF)

Answer 6

TNOCF = SalvageT + NWCInv - T * ( SalvageT - BookT )

Question 7

Procedures for selecting between mutually exclusive projects with different lives

Answer 7

(1) Least Common Multiple Approach : replacement chain

(2) Equivalent Annual Annuity (EAA) Approach: finds the sequence of annual payments that is equal to the project’s NPV

Question 8

Methods of evaluating profitability of investment with real options

Answer 8

(a) Determine the NPV of the project without the option – if NPV of project without the option is positive, the project with option must be at least as valuable
(b) Calculate the NPV without option and add the estimated value of the real option

overall NPV = project NPV (via DCF) - option cost + option value

Question 9

Alternatives to discounted incremental cash flow approach to budgeting

Answer 9

(1) Economic Income: after-tax cash flow plus the change in investment’s MV
(2) Accounting Income: reported NI on a financial statements that results from investment in a project

Question 10

Economic Income

Answer 10

economic income = cash flow + (EndMV - BeginMV)

economic income = cash flow - economic depreciation

where

economic depreciation = (BeginMV - EndMV)

Question 11

Economic Profit

Answer 11

Measure of profit in excess of the dollar cost of capital invested in a project.

EP = NOPAT - $WACC

EP = EBIT (1-t) - WACC * Capital

Question 12

Market Value Added (MVA)

Answer 12

NPV = MVA = SUM_t [ EP_t / ( 1 + WACC )^t ]

Question 13

Residual Income

Answer 13

focuses on returns on equity and is determined by subtracting an equity charge from accounting net income

RI_t = NI_t - ( r_e * B_(t-1) )

Question 14

Calculation of economic depreciation for EI

Answer 14

Recall EI = CF - economic depreciation

Given a timeline of the cash flows, the economic depreciation can be PV(V0) - PV(V1) where Vx is the present value of the cash flows at time x.

Question 15

Calculating NPV in scenario analysis

Answer 15

Get to the point where you can exercise the option, Vx. Calculate the NPV the the two scenarios (high vs low). One will have positive value, so then multiply that by the probability of that scenario happening and then discount back to V0.

Question 16

Value of equity at time 0

Answer 16

One problem in the curriculum used the PV of all the payments to equity (divs and share repurchases). The key was that the company was dissolving at the end of the period.

Question 17

Effect of increasing initial outlay

Answer 17

Increasing by y has two effects:

(a) increases your initial outlay by y
(b) Increases the value of the tax shield by y*tax

Question 18

Value of Levered Firm

Answer 18

VL = EBIT (1 - tax) / r_wacc

Question 19

Effect of increase in tax on cost of debt

Answer 19

Taxes increase, cost of debt decreases

Question 20

Calculating the required return on equity

Answer 20

r_e = r_0 + ( r_0 - r_d) * ( 1-tax ) * ( D/E )

Question 21

Value of Levered Firm using using MM Prop 1 with taxes

Answer 21

VL = VU + tD