Chapter 10 & 11 Flashcards
Making capital investment decisions; Project analysis and evaluation
Relevant cash flows
- The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur!) if the project is accepted.
- Change in the firm’s overall future cash flow that comes as a direct
consequence of the decision to take the project. - These cash flows are called incremental cash flows.
Stand-alone principle
The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows.
Common types of cash flows
Sunk costs
Opportunity costs
Side effects
Changes in net working capital
Financing costs
Taxes
Sunk costs
A cost already paid or have already incurred the liability to pay
Opportunity cost
The most valuable alternative that is given up if a particular investment is undertaken
Side effects
Incremental cash flows for a project include all the resulting changes in the firm’s future cash flows.
Erosion: negative impact on the cash flows of an existing product from the introduction of a new product.
Net working capital
The project may also entail NWC requirement. NWC typically can be recovered fully (at book value) at the end.
Operating cash flow (OCF)
OCF = EBIT + depreciation - taxes
OCF = net income + depreciation (when there is no interest expense)
Cash Flow from Assets (CFFA)
Cash Flow from Assets (CFFA) = OCF - net capital spending (NCS) - changes in NWC
Pro forms financial statement
Financial statements projecting future years’ operations.
Unit sales (Q)
Revenues (P)
Variable costs (VC)
Total fixed costs (FC)
Total investment required (NFA)
Investment in NWC
Depreciation
Depreciation is a non-cash expense, it is only relevant because it affects taxes.
Depreciation tax shield = D * T
D=depreciation expense
T=marginal tax rate
Straight-line depreciation = initial cost / number of years
OCF Bottom-up approach
OCF = NI + depreciation
Only works only when there is no interest expense
OCF Tax shield approach
OCF = (sales-costs)(1-T) + depreciation*T
OCF Top-down approach
OCF = Sales - Costs - Taxes
Do not subtract non-cash deductions
Equivalent Annual Cost (EAC)
The present value of project’s costs calculated on an annual basis.
Forecasting risk
The possibility that errors in projected cash flows will lead to incorrect decisions.
Scenario and what-if analyses
Scenario analysis: investigation of impacts on NPV by changes in assumptions about a group of variables
▪ Best case – high revenues, low costs
▪ Worst case – low revenues, high costs
▪ Measures of the range of possible outcomes
we examine many variables taking on few different values, in combination.
Sensitivity analysis
Subset of scenario analysis where we are looking at the effect of specific variables on NPV.
The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay its estimation.
we examine one variable taking on many different values, one variable at a time.
Simulation analysis
Expanded sensitivity and scenario analysis. Simulation can estimate thousands of possible outcomes based on conditional probability distributions and constrains for each of the variables.
The output is a probability distribution for NPV with an estimate of the
probability of obtaining a positive net present value.
combination of the two: we examine many variables taking on many different values, in combination.
Break-even analysis
Form of sensitivity analysis. Variable that leads to NPV=0
▪ Total variable costs = quantity × cost per unit
▪ Fixed costs are constant, regardless of output, over some time period.
▪ Total costs = fixed + variable = FC + VC*Q
Average vs marginal cost
Average cost: TC/number of units ; will decrease as number of units increases
Marginal cost: the cost to produce one more unit, same as variable cost per unit
3 types of break-even analysis
- Accounting Break-even
Where NI = 0
Q = (FC + D)/(P – VC) - Cash Break-even
Where OCF = 0
Q = (FC + OCF)/(P – VC); (ignoring taxes) - Financial Break-even
Where NPV = 0 - Cash BE < Accounting BE < Financial BE
Operating leverage
The degree or which a firm or project relies on fixed costs.
Degree of operating leverage (DOL) = 1 + (FC/OCF)
Capital rationing
The situation that exists if a firm has positive NPV projects but cannot find the necessary financing. 2 kinds of capital rationing:
* Soft rationing: the firm itself sets constraints on its various divisions, necessary funds are available at the firm level motivated by maintaining control and keeping track of spending.
* Hard rationing: the firm cannot raise financing for a positive NPV project under any circumstances in its essence, this is due to capital market imperfection
