chapter 8 Flashcards
capital budget
lists the project and investments that a company plans to undertake during the coming year.
capital budgeting
the process of determining the capital budget by analysing alternative projects and decide which ones to accept. the ultimate goal is to determine the effect of the decision on the firm’s cash flows and evaluate the NPV of these cash flows to assess the consequences of the decision for the firm’s value.
incremental earnings
the incremental earnings of a project is the amount by which the firm’s earnings are expected to change as a result of the investment decision.
straight-line depreciation
the simplest method of depreciation, in which the asset’s cost (less any expected salvage value) is divided equally over its estimated useful life.
unlevered net income
net income not including any interest expenses associated with debt.
marginal corporate tax rate
the tax rate it will pay on an incremental dollar of pre-tax income. this is the correct tax rate to use for the unlevered net income formula.
opportunity cost
the opportunity cost of using a resource is the value it could have provided in its best alternative use. we include this as an incremental cost of the project.
project externalities
indirect effects of the project that may increase or decrease the profits of other business activities of the firm.
cannibalisation
when sales of a new product displace sales of an existing product.
sunk cost
any unrecoverable cost for which the firm is already liable. sunk costs have been or will be paid regardless of the decision about whether or not to proceed with a project. eg. fixed overhead costs and R&D.
overhead expenses
associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation.
free cash flow
the incremental effect of a project on the firm’s available cash, separate from any financing decisions. it is calculated on an unlevered basis (ie. it ignores financing items like interest expenses). free cash flows are cash flows available to financiers (debt and equity holders).
depreciation
is not a cash expense that is paid by the firm. it is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life. it is not a cash flow, so it is not included in the cash flow forecast.
receivables
a firm’s receivables measure the credit the firm has received from its suppliers.
trade credit
the difference between receivables and payable is the net amount of the firm’s capital that is consumed as a result of credit transactions.
depreciation tax shield
the tax savings that result from the ability to deduct depreciation. consequently, depreciation expenses have a positive impact on free cash flow. it is tc * depreciation.
Modified Accelerated Cost Recovery System/MACRS depreciation
categorises assets according to their recovery period and specifies a fraction of the purchase price the firm can depreciate each year.
bonus depreciation
allows firms to deduct an additional portion of the purchase price when the asset is first placed into service. this is sometimes provided by the tax code.
terminal or continuation value
represents the market value (as of the last forecast period) of the free cash flow from the project at all future dates. it is useful if a project has an erratic start but stable long-term cash flows.
tax loss carry-forwards and carry-backs
allow corporations to take losses during a current year and offset them against gains in nearby years.
NPV break-even level of input
the level for which the investment has an NPV of zero.
EBIT break-even
the EBIT break-even for sales is the level of sales for which the project’s EBIT is zero.
break-even analysis
in a break-even analysis the value at which the NPV of the project is zero is calculated for each parameter.
sensitivity analysis
breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. it allows us to explore the effects of error in our NPV estimates for the project.
scenario analysis
considers the effect on the NPV of changing multiple project parameters. because certain factors affect more than one parameter.
capital expenditures (CapEx)
actual cash outflows when a fixed asset is purchased. it is included in calculating FCF.
salvage value
some fixed assets can be sold at the end of the project. there are often tax effects involved.
NPV break-even level of discount rate
is the Internal Rate of Return (IRR).
incrementality principle
include only changes in profits, eg. changes in sales or costs, etc.
opportunity cost of capital
the expected rate of return that can be earned on alternative investments with the same characteristics (risk, maturity). so, what we can earn with our investments compared to investing on the securities market.
Weighted Average Cost of Capital (WACC)
the cost of capital if the average risk of the project is equal to the average risk of the firm. it is the weighted average of the cost of equity and the cost of debt and the market value of equity and debt are used as weights. it can only be used for projects where the risk is similar to the average risk of the firm.
dividend discount model
discounting the dividends.
sensitivity analysis
gives the different numbers that lead to the NPV break-even, eg. units sold number or sales price.
NPV break-even levels
useful to determine how sensitive the NPV result is to change in the input factor. it also shows at what input level the decision changes.
