Chapter 8 - Fundamentals of capital budgeting

Question 1

What is capital budgeting?

Answer 1

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

Question 2

What is a capital budget?

Answer 2

A capital budget is a list of all the projects and investments that a corporation plans to undertake during the following year.

In order to determine this list, the company must first decide which projects that are to be included in the list. To do this, they should estimate and analyze the cash flows that result from each of them, and accept the ones with best NPV.

Question 3

What is the first step of capital budgeting?

Answer 3

The first step is to identify the consequences of a project.

Some projects will hit the revenues.
Other projects will hit costs.
Regardless of what it will hit, the ultimate goal is to identify its impact on the cash flows, so that we can evaluate the resulting NPV of these cash flows to assess the outcome of the project.

Question 4

Are earnings cash flows?

Answer 4

No. however, financial managers usually start with predicting the incremental earnings from a project, and then after this convert it to a cash flow (or at least forecast it as a cash flow).

Question 5

do we include interest expense in our forecast for cash flow?

Answer 5

No. The financing decision is completely separate from the investment decision. We are not interested in it.

We use the term unlevered income to signal that the income does not include any interest expense associated with debt.

Question 6

What is the formula for unlevered net income?

Answer 6

Question 7

do we need taxes in our cash flow estimate?

Answer 7

Yes. we need to use the marginal tax rate. Each additional dollar of pretax income must be included.

Question 8

What sort of indirect effects can a project have?

Answer 8

We are primarily talking about opportunity costs and externalities.

Opportunity cost is commonly neglected in cases where the firm already owns the resources needed, so it doesnt have to spend cash on them. This is WRONG, as the resources have other uses. If anything, the resources have a market value and can be sold. The important thing is that the opportunity cost must be included.

Question 8

Name example of opportunity cost when a project requires building a new lab

Answer 8

Say the lab is to be built in a facility that the company owns. the company will then at least loose the rent-price it would otherwise get. This is a loss of income, and must be included in the incremental earnings. the after-tax benefit loss must be added.

Question 9

Define sunk costs

Answer 9

Not relevant. They are not to be considered in the incremental earnings.

A common pitfall is to include already-payed marketing research in the incremental earnings for the project. This is wrong, they are not relevant.

Question 9

How do we deal with the depreciation “cost” when calculating the free cash flow?

Answer 9

Depreciation is an accounting thing, so we dont give a fuck about it.

What we do, is remove all of the depreciation costs, and rather include the price we actually pay for the machine or asset instead. This makes it closer to a cash flow.

So, we add back (to the earnings) the depreciation cost, and place the cost of the asset(s) at the appropriate year(s).

Question 9

what is cannibalization?

Answer 9

Cannibalization is a term we use when a new product displace sales of an existing product.

The important part about cannibalization is that we include it in the incremental earnings.

NB: There are many effects in play. if we launch a new console, ps5, the ps4 sales will be reduced drastically. Therefore, we dont get that revenue anymore. At the same time, we dont need to produce that many ps4, so we reduce our costs.
All of these effects must be included in the incremental earnings.

Question 10

something to be OBS about the incremental earnings?

Answer 10

Earnings are not the same as cash flows. They include depreciation as a cost.

Question 10

What is the sunk cost fallacy?

Answer 10

Continue with a shit project just because we have already spent a lot of money on it.

Question 11

Define free cash flow

Answer 11

Free cash flow refers to the incremental cash flow that a project will carry, separate from any financial decision.

Question 11

Define trade credit

Answer 11

trade credit is the difference between accounts receivables and accounts payables.

Question 12

most projects will require the firm to invest in net working capital. For instance, to keep a minimum cash balance in case some shit happens or other things.

What is the effect of having to invest in net working capital?

Answer 12

Investing in net working capital basically means a reduction in cash. Therefore, it is a negative cash flow.

We refer to the trade credit as the difference between account receivables and account payables, and it represent the net amount of capital that is consumed from all the transactions.

Recall that the net working capital is defined mathemtically as:

NWC = Current Assets - Current Liabilities

NWC = Cash + inventory + Receivables - Payables

Question 13

Question 14

Give the formula for free cash flow that does not use the standard way of forecasting earnings first

Answer 14

Question 15

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

Answer 15

We can ignore the cash flows that are identical for the projects in question.

Question 16

What are the most difficult aspects (typically) of capital budgeting?

Answer 16

Estimating the cash flows

Estimating the cost of capital

Question 16

After we have found the complete free cash flow, then what do we do?

Answer 16

We need to discount it. To do this, we have to consider the element of risk, as the cost of capital must include the risk aspect.

Question 16

How should depreciation be used?

Answer 16

We use hte most accelerated method, as this is in our best interest.

Question 16

Should non-cash items be included as part of the incremental earnings?

Answer 16

no, in general we do not include non cash items

Question 16

What is depreciation tax shield?

Answer 16

taxRate x Depreciation, is called the depreciation tax shield. It is a benefit for corporations. It represent tax savings that result from the ability to depreciate assets.

Question 16

What is our first weapon of choice when we are uncertain about some of the inputs we need to perform capital budgeting, like unknown cost of capital for instance?

Answer 16

We use break even analysis.

BEA is about solving the free cash flow for an NPV of 0, and solving it for the unknown. This gives us a value for the unknown that we can use as a limit. Limits can be easier to work with than having to compute an exact number. This is because it is often easier to say that we KNOW it is below a certain value or above it, but cannot be more precise than that.

Question 16

What is EBIT break even?

Answer 16

The value of some parameter for which the EBIT projection is 0.

Question 17

How does the graphical result of sensitivity analysis look?

Answer 17

The main estimate value is placed along the middle. The far ends represent worst case and best case scenarios.

There is also a line that represent the break even values.

Question 18

Describe scenario analysis with one sentence

Answer 18

We vary “all” parameters so that they represent a certain scenario, and compute the NPV of that scenario.

To add, the sensitivity analysis look at cases where we only change one parameter at a time. Scenario analysis provide a different approach.

Question 19

What is the “other” way of writing the equation for free cash flow?

Answer 19

We can rewrite the original equation which will give us this:

FCF = (revenue - costs)x(1-t) + depreciation x t - CapEx - ∆NWC

The part: depreciation x t is called the depreciation tax shield. In terms of projects and cash flow, it represent a positive cash flow impact for us.

Question 20

Explain the extremely important effect of depreciation

Answer 20

The depreciation tax shield.

its important effect is that depreciation tax shield is treated as positive cash flow. Because of this, we want to have as much value as possible EARLY from the tax shield. Accelerated depreciation.