Ch 08: Fundamentals of Capital Budgeting Flashcards
Capital budgetin
Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept.
capital budget
A capital budget is a list of all projects that a company plans to undertake during the next period
NPV rule in relation to capital budgeting
We use the NPV rule to evaluate capital budgeting decisions, making decisions that maximize NPV. When deciding to accept or reject a project, we accept projects with a positive NPV.
When do we accept or reject a project?
When deciding to accept or reject a project, we accept projects with a positive NPV.
the incremental earnings of a project…
the incremental earnings of a project comprise the amount by which the project is expected to change the firm’s earnings
Incremental earnings should include…
Incremental earnings should include all incremental revenues and costs associated with the project, including project externalities and opportunity costs, but excluding sunk costs and interest expenses
Project externalities
cash flows that occur when a project affects other areas of the company’s business
sunk cost
A sunk cost is an unrecoverable cost that has already been incurred
We estimate taxes using…
We estimate taxes using the marginal tax rate, based on the net income generated by the rest of the firm’s operations, as well as any tax loss carrybacks or carryforwards.
When evaluating a capital budgeting decision, we first…
Thus…
We first consider the project on its own, separate from the decision regarding how to finance the project. Thus, we ignore interest expenses and compute the unlevered net income contribution of the project
Unlevered Net Income
EBIT * (1 - T)
= (Revenues - Costs - Depreciation) * (1-Tc)
We compute free cash flow from incremental earnings by…
eliminating all non-cash expenses and including all capital investment
Depreciation is not a cash expense, so it is added back.
Actual capital expenditures are deducted. Increases in net working capital are deducted.
Net working capital formula
Cash + Inventory + Receivables - Payables
Free Cash Flow Basic Calculation
Unlevered Net Income + Depreciation - CapEx - Change in NWC
= (Rev - Cost - Depreciation) * (1 - Tc) + Depreciation - CapEx - Change in NWC
The discount rate for a project is…
its cost of capital: The expected return of securities with comparable risk and horizon.