Chapter 8 - Capital budgeting

Question 1

Define capital budgeting

Answer 1

Capital budgeting is the process of analyzing investments and selecitng which ones to include in your portfolio of investment

Question 2

Whati s the most reliable method to decide which projects to accept and which to not?

Answer 2

the NPV rule methos

Question 3

Define a capital budget

Answer 3

A capital budget is the list of projects/investments that the firm has chosen to include in the portfolio

Question 4

How do firms choose their capital budget?

Answer 4

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.

Question 5

What is the ultimate goal of capital budgeting?

Answer 5

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.

Question 6

Key thing about earnings of a firm?

Answer 6

Earnings is not cash flow. Earnings is an accounting shite that include lots of shite.

Question 7

What do finacial managers typically start with in terms of the forecasting process?

Answer 7

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.

Question 8

What is depreciation

Answer 8

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.

Question 9

what is EBIT

Answer 9

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”.

Question 10

What is unlevered net income?

Answer 10

Unlevered refers to no debt, so no interest is being payed

Question 11

Key thing about computing taxes?

Answer 11

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

Question 12

What is the formula for unlevered net income?

Answer 12

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

=

Question 13

Shortly, what costs must be included in the analysis of incremental cash flows in the capital budgeting process?

Answer 13

Of course the direct effects.

However, we also have to consider indirect effects:
- Opportunity cost
- externalities, like cannibalization

Question 14

Explain why sunk cost is a part of the incremental cash flow

Answer 14

It is not

Question 15

What is the concorde effect?

Answer 15

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.

Question 16

Elaborate on the effect that opportunity cost has on a project

Answer 16

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.

Question 17

When we talk about the term “earnings” what are we actually talking about?

Answer 17

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.

Question 18

What is the outcome of “earnings” being an accounting term?

Answer 18

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.

Question 19

The incremental effect that a project or investment has on the firms cash flows is called …?

Answer 19

Free cash flow

Question 20

Why is it called “free” cash flow?

Answer 20

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.

Question 21

name some challenges with earnings that we need to do something about to get the FCF

Answer 21

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.

Question 22

Elaborate on net working capital, NWC

Answer 22

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.

Question 23

NWC highlight the fact that we use terms like “receivables” and “payables”. Why is this important?

Answer 23

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.

Question 24

Define trade credit

Answer 24

Trade credit is the differnce between “Receivables - Payables”.

Question 25

Why do we need net working capital in capital budgeting?

Answer 25

It is required when computing free cash flows.

why?

Because the free cash flow is based on revenue.

We first need to compute the after tax income.

(Revenue - costs - depreciation)x(1-taxRate)

Now, since depreciation is not an outflow, we add it back ( we have gained the tax benefit).

(revenue - cost - depreciation) x (1-taxRate) + depreciation

to get closer to the free cash flow, we must include capital expenditures

(revenue - cost - depreciation) x (1-taxRate) + depreciation - cap ex

And then finally, we add changes to NWC. This is to adjust for shit we have not yet received or payed.

(revenue - cost - depreciation) x (1-taxRate) + depreciation - capex - ∆NWC

Question 26

What is the FCF formula?

Answer 26

(revenue - cost - depreciation) x (1-taxRate) + depreciation - cap ex - ∆NWC

Question 27

Name the most important result we can gain from the formula for FCF

Answer 27

Depreciation tax shield. This represent the amount of cash we basically save from the tax benefit of having depreciated things.

Question 28

Main difference between capex and ∆nwc

Answer 28

One is long term, the other is short term.

Non current vs current

Question 29

key point when comparing mutually exclusive projects?

Answer 29

We only need to consider the cash flows that differ between them. in some cases, this can significantly reduce the cmplexity of the task.

Question 30

when choosing between alternatives, what cash flows can be ignored?

Answer 30

Cash flows that are the same for all the alternatives can be ignored

Question 31

Name the usual suspects that make estimating future cash flow more tricky

Answer 31

1) Non cash charges
2) Alternative depreciation methods
3) Liquidation or continuation values
4) Tax loss carryforwards

Question 32

Elaborate on non cash charges

Answer 32

In general, only cash items are included as part of the incremental earnings. The same goes for non cash expenses. Say amortization of intangibles. These are typically added back to find unlevered income.

Question 33

What can we say about depreciation?

Answer 33

THe firm should always choose the most accelerated method.

Question 34

Elaborate on how salvage value is handled

Answer 34

THe salvage value is a taxable amount.

we need to find the gain on the sale. Will be equal to sale value - book value.
Then we need to tax this.

(Sale value - book value) x (1-taxRate)

However, the book value is equal to Purchase price - accumulated depreciation.

The final result is basically: Salvage = Sale Price - gainOnSale x taxRate

Question 35

Elaborate on how we deal with projects that has an infinite continuation value

Answer 35

The thing here is that we often assume a short horizon, but the firm actually might continue the project for a very long time.

it is common to treat such cases as a constant growth perpetuity.

Question 36

What is the formula for perpetuity of constant growth

Answer 36

CashFlow / (r - g)

if we want no growth, just basically the same cash flow every year, we set g=0.

Recall that there are two requirements:
1) r-g must be smaller than 1.
2) r-g must be positive.

Question 37

elaborate on break even analysis

Answer 37

done for a single input. It is about figuring out what levels of value for this input that can be tolerated before the project goes to 0 or negative NPV.

THe IRR is one type of break even analysis.

Question 38

elaborate on sensitivity analysis

Answer 38

we define upper and lower limits of the various inputs, representing best case and worst case scenarios. Then we compute the effects of the differnet levels on the free cash flows.

Question 39

What is scenario analysis

Answer 39

A type of sensitivity analysis that picks out a likely scenario and computes the NPV of the project given this scenario of values.

Question 40

Sum up break even analysis, sensitivbity analysis and scenario analysis

Answer 40