Capital Budgeting

Question 1

What does NPV represent?

Answer 1

NPV represents the wealth that will be added to the firm when the project decision is made. It also represents the value added to the project’s opportunity cost of capital.

Question 2

What can be included in the numerator of NPV?

Answer 2

To be included, the item must have three features:

• Incremental
  
  • Cash flows that will change as a result of undertaking the project
• Operating
  
  • Distinct from financing cash flows, such as debt interest
  • Examples: cash sales; wages paid; cash purchases of raw materials
• Cash flows
  
  • Valued at the date it will occur
  • Exception: depreciation

Question 3

What is the IRR

Answer 3

A project’s IRR is the discount rate that would give a NPV of zero.

Question 4

Mention the advantage and disadvantage of IRR.

Answer 4

• Disadvantage
  
  • Only works with conventional cash flow patterns
  • May result in conflicting result with NPV in the case of “mutually exclusive” projects
• Advantage
  
  • Easy to relate to
  • Tells something about the sensitivity to forecast errors
    
    • Higher IRR leads to a higher tolerance to cashflow forecast errors

Question 5

What is PP?

Answer 5

The payback period is the time taken to recover the project’s initial outlay.

Question 6

Mention the advantage and disadvantage of PP.

Answer 6

• Disadvantage
  
  • It uses an arbitrary cut-off point
  • Ignores cash flows after the cut-off point
  • Ignores the time value of money
• Advantage
  
  • Easy to relate to
  • Beneficial if the company is liquidity constrained
  • Cash flow outcomes provide information

Question 7

What is ARR?

Answer 7

ARR is based on accounting profit rather than cash flows. It differs from net cash flow, in particular the treatment of:

• Depreciation & Capital outlays
  
  • Capital outlays are spread over the life of the capital by charging depreciation each year, rather than a cash outflow at time zero.

Question 8

Mention some of the common problems in cash flow estimation.

Answer 8

1. Sunk costs and benefits
   
   • Cash flows that have already occurred => shouldn’t affect future decisions
   • Can’t be incremental
2. Allocated Costs
   
   • Usually not incremental, except the costs allocated are only expended in the condition of the project being done
3. Residual values
   
   • Non-zero value of the asset at end of life
   • Incremental and therefore included in NPV analysis
4. Financing charges
   
   • Not operating cash flows - not included in NPV
   • However, it is reflected in the denominator - in the required rate of return

Question 9

How to take inflation into account in the NPV?

Answer 9

Question 10

What is the company tax?

Answer 10

Company tax is tax payable by a company on its taxable income (“profit”). Company’s taxable income is equal to:

• Cash Inflow - Cash Outflow - “Allowable Deductions”

Question 11

What are examples of allowable deductions?

Answer 11

• Depreciation: either through
  
  • Prime Cost Method: rate equals to 1/n, where n is the expected life time
  • Diminishing Value Method: deductions are greater in the early years (2x PCM rate)
• Interest on debt

Question 12

What is the WACC?

Answer 12

The weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

Question 13

Can we use the required rate of return of the company’s existing projects to discount the expected cash flows of a proposed project?

Answer 13

Yes, but only if the new project is “typical” or of the same nature of the company existing projects (asssets)