Ch 08: Fundamentals of Capital Budgeting

Question 1

Capital budgetin

Answer 1

Capital budgeting is the process of analyzing investment opportunities and deciding which ones to accept.

Question 2

capital budget

Answer 2

A capital budget is a list of all projects that a company plans to undertake during the next period

Question 3

NPV rule in relation to capital budgeting

Answer 3

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.

Question 4

When do we accept or reject a project?

Answer 4

When deciding to accept or reject a project, we accept projects with a positive NPV.

Question 5

the incremental earnings of a project…

Answer 5

the incremental earnings of a project comprise the amount by which the project is expected to change the firm’s earnings

Question 6

Incremental earnings should include…

Answer 6

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

Question 7

Project externalities

Answer 7

cash flows that occur when a project affects other areas of the company’s business

Question 8

sunk cost

Answer 8

A sunk cost is an unrecoverable cost that has already been incurred

Question 9

We estimate taxes using…

Answer 9

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.

Question 10

When evaluating a capital budgeting decision, we first…

Thus…

Answer 10

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

Question 11

Unlevered Net Income

Answer 11

EBIT * (1 - T)

= (Revenues - Costs - Depreciation) * (1-Tc)

Question 12

We compute free cash flow from incremental earnings by…

Answer 12

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.

Question 13

Net working capital formula

Answer 13

Cash + Inventory + Receivables - Payables

Question 14

Free Cash Flow Basic Calculation

Answer 14

Unlevered Net Income + Depreciation - CapEx - Change in NWC

= (Rev - Cost - Depreciation) * (1 - Tc) + Depreciation - CapEx - Change in NWC

Question 15

The discount rate for a project is…

Answer 15

its cost of capital: The expected return of securities with comparable risk and horizon.

Question 16

When choosing between mutual exclusive investment opportunities, pick the opportunity with the highest …

Answer 16

NPV

Question 17

Depreciation expenses affect free cash flow only through the…

Answer 17

depreciation tax shield. The firm should generally use the most accelerated depreciation schedule that is allowable for tax purposes.

Question 18

When an asset is sold, tax is due on the difference between…

Answer 18

the sale price and the asset’s book value net of depreciation

Question 19

Terminal or continuation values should reflect the present value…

Answer 19

of the project’s future cash flows beyond the forecast horizon.

Question 20

Break-even analysis computes the level of a parameter that makes the project’s NPV…

Answer 20

equal zero.

Question 21

Sensitivity analysis breaks the NPV calculation down into its

Answer 21

component assumptions, showing how the NPV varies as the values of the underlying assumptions change.

Question 22

Scenario analysis considers the effect of

Answer 22

changing multiple parameters simultaneously. It is common to consider multiple scenarios. We can weight the scenarios by their likelihoods to compute an expected NPV