Chapter 8 - Capital budgeting Flashcards
Define capital budgeting
Capital budgeting is the process of analyzing investments and selecitng which ones to include in your portfolio of investment
Whati s the most reliable method to decide which projects to accept and which to not?
the NPV rule methos
Define a capital budget
A capital budget is the list of projects/investments that the firm has chosen to include in the portfolio
How do firms choose their capital budget?
Capital budget, the list of investments and projects to partake in, is selected through capital budgeting. This is a process where the firm start by forecasting the future consequences of the various projects and investemnts, in terms of their effect on the firm. Typically this boils down to NPV.
What is the ultimate goal of capital budgeting?
Determine the effect that a project/invstment has on the firm, in terms of cash flows.Why? We need to find the cash flow effect, because this is required to find the net present value of the project.
Key thing about earnings of a firm?
Earnings is not cash flow. Earnings is an accounting shite that include lots of shite.
What do finacial managers typically start with in terms of the forecasting process?
Start by forecasting earnings. This might be counter intuitive.
More specifically, we start by forecasting the incremental earnings. The incremental earnings is the additional earnings that the project carry.
The reason why we start by forecasting incremental earnings, and not say the revenue, is that it is easier to find the cash flow this way, and not the other way around (starting at revenue/sales). Given earnings, there is the fixed tax and the depreciation and amortization that must be taken care of to find cash flow.
What is depreciation
Depreciation is a cost, but it is not cash flow. Depreciation stems from any capital expenditure that is not related to the regular operation. Examples include plant and property, but also things like equipment. THe point is that the financial statement should provide a more stable version of how the firm is operating.
what is EBIT
Earnings before interest and taxes. Key point is that EBIT is a measure where depreciation has been deducted.
EBIT includes the depreciation and amortization as a cost. In norwegian, it is called “driftsresultat”.
What is unlevered net income?
Unlevered refers to no debt, so no interest is being payed
Key thing about computing taxes?
We use EBIT, and not EBITDA. Why? Because we naturally want to keep as much money as possible, which means reducing taxes. Since depreciation is an accounting cost, and we are taxed on the earnings, we keep the depreciation as high as possible.
Income tax = EBIT x taxRate
What is the formula for unlevered net income?
Unlevered net income = (EBIT) x (1 - taxRate)
= (Revenue - Costs - Depreciation) x (1 - taxRate)
= Revenue + Revenue x taxRate - costs + costs x taxRate - depreciation + depreciation x taxRate
=
Shortly, what costs must be included in the analysis of incremental cash flows in the capital budgeting process?
Of course the direct effects.
However, we also have to consider indirect effects:
- Opportunity cost
- externalities, like cannibalization
Explain why sunk cost is a part of the incremental cash flow
It is not
What is the concorde effect?
Sunk cost fallacy where extreme amounts of cash into a project, that by all defintions are sunk costs, creates a scenario where people feel like they must continue the project.
Elaborate on the effect that opportunity cost has on a project
we have to include it because opportunity cost would represnet something we give up. For instance, if we building could be used as a whorehouse for $1 000 000 a year revenue, and we consider using it is a factory instead, we loose the million.
When we talk about the term “earnings” what are we actually talking about?
Earnings is an accounting term. Earnings is supposed to measure the firms performance. THEY DO NOT REPRESENT PROFIT.
This is crucial to understand. THe firm cannot use the earnings to buy goods. They cannot use the earnings to do shit. The earnings cannot be used to pay dividends.
In corporate finance, we are more interested in cash flows than earnings. Why? A firm needs cash to operate at a high level. We dont give a fuck about the accounting earnings.
What is the outcome of “earnings” being an accounting term?
We want to focus on the actual cash flow. Therefore, we must transform the earnings, as they are given on the finaical statements etc, into meaningful cash flows that makes sense to us. The key is that we want the sum of CASH that the firm receives and have available to use etc.
The incremental effect that a project or investment has on the firms cash flows is called …?
Free cash flow
Why is it called “free” cash flow?
Recall free cash flow refers to the incremental effect that a project has on the firm.
Since this is only additional cash flow, we can consider the incremental cash as available to use for whatever. Therefore, we coin it free.
Thus, FCF is a term that highlight the additional cash flow a project generate which can be used for future spendnings or dividends etc.
name some challenges with earnings that we need to do something about to get the FCF
Earnings include depreciation, but this is not cash flow.
We have the capital expenditure, which we want to include.
We do not want ot include depreciation, but we want to include the capex.
Elaborate on net working capital, NWC
NWC = Current assets - current liabilities
NWC = cash + inventory + receivables - payables
This of course means that net working capital is not a flow. It is a holding sum, representing a balance. In other words, it is a section on the balance sheet, which means that it is asset related.
NWC highlight the fact that we use terms like “receivables” and “payables”. Why is this important?
In the real world, we are interested in cash that we can use. Earnings does not represent cash we can use. Receivables are cash that we dont currently have. We have been promised then, but not received it. Therefore, we cant treat it like cash. It is an asset, but not cash.
Define trade credit
Trade credit is the differnce between “Receivables - Payables”.
