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AFM 273 > Chapter 9 > Flashcards

Chapter 9 Flashcards

fundamentals of capital budgeting

1
Q

what’s an important responsibility of corporate financial managers

A

determining which projects/investments a firm should undertake

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2
Q

define capital budget

A

lists all of the projects that a company plans to undertake during the next period

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3
Q

define capital budgeting

A

the process of analyzing investment opportunities and deciding which ones to accept - begins with forecasts of the project’s future consequences for the firm.

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4
Q

are earnings cash flows

A

earnings are not actual cash flows

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5
Q

define incremental earnings

A

the amount by which a firm’s earnings are expected to change as a result of an investment decision

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6
Q

why use CCA in capital budgeting

A

PP&E = cash expense but not expenses when calculating earnings - firm deducts CCA instead for tax purposes as CCA affects the company’s taxable income, the actual amount of tax paid and the firm’s actual cash flows

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7
Q

define CCA

A

the canada revenue agency method of depreciation used for tax purposes

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8
Q

how to calculate the annual CCA deductions

A
  1. determine the tax year in which the purchase takes place
  2. determine asset class and the relevant CCA rate - CRA has a “half-year rule”
  3. gets us to EBIT
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9
Q

how can CCA deductions continue forever

A

bc the UCC will never fall to zero bc CCA calculation will always deduct a proportion of UCC with a CCA rate (less than 100%) - as long as the assets isn’t sold

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10
Q

define tax year

A

the fiscal year relevant for tax and CCA calculations for the CRA

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11
Q

define asset class

A

categories defined by the CRA to indicate types of depreciable properties that will be given the same treatment for capital cost allowance calculations

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12
Q

define CCA rate

A

the proportion of undepreciated capital cost (UCC) that can be claimed as capital cost allowance (CCA) in a given tax year

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13
Q

define half-year rule

A

as assets may be purchased at any time throughout a year, it can be assumed that on average an asset is owned for half a year during the first tax year of its ownership. thus the CRA allows only half of CapEx to generate CCA in the first tax year (year in which a purchase takes place)

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14
Q

define UCC

A

underdepreciated capital cost - the balance at a point in time, calculated by deducting an asset’s current and prior CCA amounts from the original cost of the asset (CapEx)

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15
Q

define asset pool

A

the sum of all assets in 1 asset class

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16
Q

what’s the formula for incremental CCA deduction that can be claimed at end of the tax year year 1 vs year 2

A

year 1
CCA = UCC x d

d = CCA rate

year 2 - add other half of CapEx into the incremental UCC.
general formula: UCC = capex * (1-(d/2)) x ((1-d)^(t-2))

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17
Q

why are earnings not an accurate representation of cash flows

A

Capex doesn’t show up as a cash outflow in earnings calculation and non-cash CCA deduction does

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18
Q

why do we not include interest expenses in capital budgeting decision evaluations

A

Any incremental interest expenses will be related to the firm’s decision regarding how to finance the project.

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19
Q

if we wish to evaluate the project on its own, separate from the financing decision and its respective cash flows

A

evaluate as if company will not used any debt to finance it

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20
Q

define unlevered net income

A

net income plus after tax interest expenses

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21
Q

define marginal tax rate

A

tax rate it will pay on an incremental dollar of pre-tax income such as what will be earned in a new project

income tax = EBIT x Tc

Tc = marginal corporate tax rate

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22
Q

can taxes be relevant when EBIT is negative

A

yes, it will reduce taxable income as long as the firm earn taxable income elsewhere in year 0 against to help offset the firm’s losses

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23
Q

how to calculate unlevered net income

A

unlevered Net Income = EBIT x (1-Tc)
= (Revenue - Costs - CCA) x (1-Tc)
projec’ts unlevered net income is equal to its incremental revenues less costs and CCA, evaluated on an after-tax basis

note: the EBIT calculated is using CCA not depreciation - must adjust EBIT as EBIT + Depreciation - CCA

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24
Q

what should we include in computing the incremental earnings of an investment decision, between the firm’s earnings with the project vs without the project

A

we should include all changes between the firm’s earnings with the project vs without the project

and the indirect effects such as affecting other operations of the firms

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25
Q

why should we include opportunity cost as an incremental cost of the project

A

bc this value is lost when the resource is used by another project

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26
Q

define opportunity of using a resource

A

is the value it could have provided in its best alternative use

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27
Q

define project externalities

A

indirect effects of the project that may increase or decrease the profits of other business activities of the firm

28
Q

define complementary products

A

products that are used together - help increase in the sales of the other product is a positive externality of the project

29
Q

define cannibalization

A

when sales of a new product displace sales of an existing product

30
Q

what’s the opportunity cost of an idle asset

A

the opportunity cost is the firm choosing to sell or rent the asset

31
Q

define sunk cost

A

any unrecoverable cost for which the firm is already liable - sunk costs have been or will be paid regardless of the decision whether or not to proceed with the project

thus they are not incremental with respect to eh current decisions + shouldn’t be included in its analysis

32
Q

what’s a good rule to remember about sunk costs and cash flow

A

if our decision doesn’t affect a cash flow, then the cash flow shouldn’t affect our decision

33
Q

define overhead expenses

A

overhead expenses - activities that are not directly attributable to a single business activity but instead affect many different area of the corporation - overhead costs are fixed + will be incurred in any case thus not incremental or project and shouldn’t be included

only include as incremental expenses the additional overhead expenses that arise bc of the decision to take on the project

34
Q

why is past research + development expenditure not included as incremental expenses for the project

A

the decision to continue or abandon should be based only on the incremental costs and benefits of the product going forward

as any money that has already been spent is a sunk cost and is irrelevant

35
Q

why are unavoidable competitive effects not included as incremental expenses in the new project

A

if sales are likely to decline in any case as a result of new products introduced by competitiors then these lost sales are a sunk cost + not included in projections

36
Q

define sunk cost fallacy

A

tendency of people to be influenced by sunk costs and to throw good money after bad - ppl continue to invest in a project that has negative NPV bc they have already invested a large amount in the project and feel that by not continuing, the prior investment will be wasted

37
Q

what other factors should be considered when estimating a project’s revenues and costs

A

the average selling price of a product and its cost of production will generally change over time. Prices and costs tend to rise with the general level of inflation in the economy. The prices of technology products, however, often fall over time as newer, superior technologies emerge and production costs decline. For most industries, competition tends to reduce profit margins over time.

A new product typically has lower sales initially, as customers gradually become aware of the product. Sales will then accelerate, plateau, and ultimately decline as the product nears obsolescence or faces increased competition.

38
Q

what’s a project free cash flow

A

the incremental effect of a project on a firm’s available cash

39
Q

earnings vs cash flow

A

earnings have non-cash charges such as CCA/depreciation and doesn’t include the cost of capital investment

40
Q

how to adjust for CCA in cash flow

A

CCA =/= included in cash flow forecast

include the actual cash cost of the asset when it’s purchased

in the earnings add the CCA deduction then subtract the actual capital expenditure paid for equipment in year 0

41
Q

define trade credit

A

The difference between receivables and payables is the net amount of the firm’s capital that is consumed as a result of these credit transactions

42
Q

what’s te formula to find free cash flow

A

(revenue - costs - CCA) x (1-tc) + CCA - CapEx - change in NWC

or

(revenues - costs) x (1-Tc) - CapEx - change in NWC + tc x CCA

43
Q

define tax shield

A

tax savings that results from the ability to deduct CCA from taxable income - CCA deduction have a positive impact on free cash flow

44
Q

what’s the PV of the expected FCF

A

PV(FCF) - FCF/(1+r)&t

= FCF x (1/(1+r)^t)

45
Q

how to evaluate alternative manufacturing plans

A

compute the FCF associated with each choice and compare their NPCs to see which is most advantageous for the firm - only need to compare those cash flows that differ between them

need to only adjust for their different net working capital requirements

46
Q

what are other items that affect or don’t the free cash flows

A

non-cash items: In general, other non-cash items that appear as part of incremental earnings should not be included in the project’s free cash flow. The firm should include only actual cash revenues or expenses.

timing of cash flows: For simplicity, we have treated the cash flows for the SPI Phone 86 as if they occur at annual intervals. In reality, cash flows will be spread throughout the year. We can forecast free cash flow on a quarterly, monthly, or even continuous basis when greater accuracy is required.

perpetual CCA tax shields: The free cash flows we estimated over the five years of the project will miss the value of CCA tax shields that occur after the project has ended. This may be a very important omission that needs to be corrected. If an asset is not sold, it will generate CCA deductions and the resulting tax shields every year into perpetuity. Since the CCA deducted each year is a proportion of the UCC, UCC never falls to zero.

47
Q

what’s the formula for the PV of CCA tax shields

A

PV = [(CapEx x D x Tc)/(r+d)] x [(1+ (r/2))/(1+r)]

48
Q

what’s the formula for FCF without CCA tax shield

A

FCF = (revenues - costs) x (1-tc) - CapEx - change in NWC

49
Q

is liquidation/salvage value included in FCF

A

yes, we include the expected liquidation value of any assets that are expected to be sold during year t. In addition, we need to include the expected tax effects from selling the asset.

50
Q

what are the 2 main tax effects of selling the asset

A

capital gain tax if the asset is sold for an amount greater than its original purchase price, denoted by CapEx - The capital gains tax will be paid in the tax year the asset is sold and will be included in the free cash flow for that year as a negative effect. When we discussed purchasing an asset at date 0, we assumed the tax effect (the CCA tax shield) would occur at date 1 because the asset was purchased just after the year 0 end-of-year for tax purposes. To be consistent, we will assume that an asset sale at date t is actually at the beginning of the tax year . Thus, given an asset sale at date t, the capital gains tax should be deducted from the free cash flow for date

the seond tax effect = subsequent CCA deduction and tax shields will change - the UCC for the asset will be reduced by the asset sale in the tax year of the asset sale - The minimum of the sale price and the original purchase price, CapEx, is subtracted from the UCC to get the post-sale UCC. If the asset is sold at date t, we will continue our assumption that the sale is at the beginning of tax year .

51
Q

define Capital gains tax

A

a tax collected on the profit from assets in the year in which the assets are sold

capital gains tax = 0.5 x (sale Price - Capex) x Tc

52
Q

how is poast-sale CCA deduction calculated?

A

depends on whether post-sale for the asset pool is positive or negative, whether or not the firm still owns any assets in that asset pool, and whether or not the firm will be buying additional assets in that pool with value greater than the asset’s expected sale price. For now, we will assume that other assets remain in the asset pool and post-sale for the asset pool remains positive. With this assumption, we have what is called a continuing pool. We will also assume that in the tax year of the asset sale, future purchases of assets (for other projects) will be less than the asset’s expected sale price; this is referred to as negative net additions.

With a continuing pool and negative net additions, adjustments must be made to the post-sale CCA amounts and resulting tax shields. The effect of the asset sale is fully recognized in the tax year of the sale, and the UCC is reduced accordingly

53
Q

define continuing pool

A

an Asset pool in which there exists positive undepreciated capital cost (UCC) and for which the company still owns assets

54
Q

define negative net additions

A

the situation when a continuing asset pool has asset purchases less than asset sales in the same tax year (the UCC of the pool will decline but still remain positive)

55
Q

what’s the formula for OV of lost CCA tax shields

A

[(min(sale Pricet, CapEx) x d x Tc)/ (r+d)] x [((1/(1+r)^t))]

56
Q

what’s some things to keep in mind about purchase price, sale price, CCA tax shields, and capital gains tax

A

The purchase price, CapEx, is a cash outflow at year 0.

The Sale Pricet is a cash inflow at year t.

The first CCA tax shield due to the asset purchase occurs at year 1, and the first lost CCA tax shield due to the asset sale occurs at year t+1. We use Eq. 9.15 to calculate the present value of all the expected CCA tax shields.

If there is a capital gain (i.e., if Sale Pricet > CapEx), then the capital gains tax is calculated using Eq. 9.12, and this tax is a cash outflow at year t+1

57
Q

define terminal (continuation) value

A

the value of a project’s remaining free cash flows beyond the forecast horizon. this amount represents the market value (as of the last forecast period) of the free cash flow from the project at all future dates

58
Q

define tax loss carryforwards and carrybacks

A

2 features of the tax code that allow corporations to take losses during a current year and offset them against gains in nearby years. in canada, companies can carry back losses for 3 years and carry forward losses for 20 years

59
Q

what happens when a company does a tax loss carryforward or carryback?

A

when a firm can carry back losses, it receives a refund for back taxes in the current year. Otherwise, the firm must carry forward the loss and use it to offset future taxable income. When a firm has tax loss carryforwards well in excess of its current pre-tax income, then the additional income it earns today will not increase the taxes it owes until after it exhausts its carryforwards. This delay reduces the present value of the tax liability.

60
Q

define break-even level

A

the level for which an investment has an NPV of zero

61
Q

define break-even analysis

A

the calculation of the value of each parameter for which the NPV of the project is zero

62
Q

why do we not do EBIT break-even

A

Because the CCA deduction is different each year, the EBIT break-even level of sales will be different each year. Because break-even analysis based on EBIT or other accounting results ignores the time value of money, such break-even values lead to negative NPV results; thus, they really are not that useful for decision-making purposes.

63
Q

define sensitivity analysis

A

an important capital budgeting tool that determines how the NPV varies as a single underlying assumption is changed

allows us to explore the effects of errors in our NPV estimates for the project

64
Q

define scenario analysis

A

an important capital budgeting tool that determines how the NPV varies as a number of the underlying assumptions are changed simultaneously

65
Q
A

AFM 273 (12 decks)

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