Chapter 9 Flashcards
fundamentals of capital budgeting
what’s an important responsibility of corporate financial managers
determining which projects/investments a firm should undertake
define capital budget
lists all of the projects that a company plans to undertake during the next period
define capital budgeting
the process of analyzing investment opportunities and deciding which ones to accept - begins with forecasts of the project’s future consequences for the firm.
are earnings cash flows
earnings are not actual cash flows
define incremental earnings
the amount by which a firm’s earnings are expected to change as a result of an investment decision
why use CCA in capital budgeting
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
define CCA
the canada revenue agency method of depreciation used for tax purposes
how to calculate the annual CCA deductions
- determine the tax year in which the purchase takes place
- determine asset class and the relevant CCA rate - CRA has a “half-year rule”
- gets us to EBIT
how can CCA deductions continue forever
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
define tax year
the fiscal year relevant for tax and CCA calculations for the CRA
define asset class
categories defined by the CRA to indicate types of depreciable properties that will be given the same treatment for capital cost allowance calculations
define CCA rate
the proportion of undepreciated capital cost (UCC) that can be claimed as capital cost allowance (CCA) in a given tax year
define half-year rule
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)
define UCC
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)
define asset pool
the sum of all assets in 1 asset class
what’s the formula for incremental CCA deduction that can be claimed at end of the tax year year 1 vs year 2
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))
why are earnings not an accurate representation of cash flows
Capex doesn’t show up as a cash outflow in earnings calculation and non-cash CCA deduction does
why do we not include interest expenses in capital budgeting decision evaluations
Any incremental interest expenses will be related to the firm’s decision regarding how to finance the project.
if we wish to evaluate the project on its own, separate from the financing decision and its respective cash flows
evaluate as if company will not used any debt to finance it
define unlevered net income
net income plus after tax interest expenses
define marginal tax rate
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
can taxes be relevant when EBIT is negative
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
how to calculate unlevered net income
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
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
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
why should we include opportunity cost as an incremental cost of the project
bc this value is lost when the resource is used by another project
define opportunity of using a resource
is the value it could have provided in its best alternative use
define project externalities
indirect effects of the project that may increase or decrease the profits of other business activities of the firm
define complementary products
products that are used together - help increase in the sales of the other product is a positive externality of the project
define cannibalization
when sales of a new product displace sales of an existing product
what’s the opportunity cost of an idle asset
the opportunity cost is the firm choosing to sell or rent the asset
define sunk cost
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
what’s a good rule to remember about sunk costs and cash flow
if our decision doesn’t affect a cash flow, then the cash flow shouldn’t affect our decision
define overhead expenses
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
why is past research + development expenditure not included as incremental expenses for the project
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
why are unavoidable competitive effects not included as incremental expenses in the new project
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
define sunk cost fallacy
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
what other factors should be considered when estimating a project’s revenues and costs
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.
what’s a project free cash flow
the incremental effect of a project on a firm’s available cash
earnings vs cash flow
earnings have non-cash charges such as CCA/depreciation and doesn’t include the cost of capital investment
how to adjust for CCA in cash flow
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
define trade credit
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
what’s te formula to find free cash flow
(revenue - costs - CCA) x (1-tc) + CCA - CapEx - change in NWC
or
(revenues - costs) x (1-Tc) - CapEx - change in NWC + tc x CCA
define tax shield
tax savings that results from the ability to deduct CCA from taxable income - CCA deduction have a positive impact on free cash flow
what’s the PV of the expected FCF
PV(FCF) - FCF/(1+r)&t
= FCF x (1/(1+r)^t)
how to evaluate alternative manufacturing plans
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
what are other items that affect or don’t the free cash flows
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.
what’s the formula for the PV of CCA tax shields
PV = [(CapEx x D x Tc)/(r+d)] x [(1+ (r/2))/(1+r)]
what’s the formula for FCF without CCA tax shield
FCF = (revenues - costs) x (1-tc) - CapEx - change in NWC
is liquidation/salvage value included in FCF
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.
what are the 2 main tax effects of selling the asset
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 .
define Capital gains tax
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
how is poast-sale CCA deduction calculated?
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
define continuing pool
an Asset pool in which there exists positive undepreciated capital cost (UCC) and for which the company still owns assets
define negative net additions
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)
what’s the formula for OV of lost CCA tax shields
[(min(sale Pricet, CapEx) x d x Tc)/ (r+d)] x [((1/(1+r)^t))]
what’s some things to keep in mind about purchase price, sale price, CCA tax shields, and capital gains tax
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
define terminal (continuation) value
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
define tax loss carryforwards and carrybacks
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
what happens when a company does a tax loss carryforward or carryback?
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.
define break-even level
the level for which an investment has an NPV of zero
define break-even analysis
the calculation of the value of each parameter for which the NPV of the project is zero
why do we not do EBIT break-even
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.
define sensitivity analysis
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
define scenario analysis
an important capital budgeting tool that determines how the NPV varies as a number of the underlying assumptions are changed simultaneously
