Chapter 9: Fundamentals of Capital Budgeting Flashcards
Capital Budget
lists the investments that a company plans to undertake during the next period
Capital Budgeting
process used to analyze alternate investments and decide which ones to accept
Incremental Earnings
the amount by which the firm’s earnings are expected to change as a result of the investment decision
Incremental Cash flows
- the additional operating cash flow that arises from undertaking a new project
- = cash flow with project - cash flow without project
Which 6 Cash Flows to Discount?
- include all indirect effects
- ignore sunk costs
- include opportunity costs
- account for working capital investment
- remember shutdown cash flows
- beware of allocated overhead costs
Would this cash flow still exists if the project did not exist? Answer: NO
include the cash flow in the analysis
Would this cash flow still exists if the project did not exist? Answer: YES
do not include the cash flow in the analysis
Ignore Sunk Costs
- irreversible outflows
- the way to identify a sunk cost is to see if it remains the same whether or not you accept the project
ex. paying $100,000 for a marketing report, its gone whether you use it or not
Include Opportunity Costs
- the value a resource could have provided in its best alternative use
ex. buying land for $50,000 and building factory or sell it for $100,000 (opp cost)
Recognize the investment in working capital
- net working capital is the difference between a firm’s short-term assets and liabilities
- most projects entail an additional investment in working capital
- at the end of the project, when inventories are sold and accounts receivable are collected, the firm has a cash inflow
Beware of Allocated Overhead Costs
when analyzing a project only include the incremental overhead expenses
which would result from the project
Nominal cash flows must be…
discounted at a nominal rate
Real cash flows must be..
discounted at a real discount rate
Interest expense in capital budgeting decisions
- typically not included
- the rationale is that the project should be judged on its own, not on how it will be financed
Tax Shields
- allows an individual or corporation to reduce taxable income
- deprecation increases costs, profit is decreased, as a result the company pays less in taxes
Depreciation is…
- NOT a cash flow
- an account construct
- “shields” the company from paying more in taxes
Capital Cost Allowance (CCA)
- the amount of write-off on depreciable assets allowed by Canada Revenue Agency against taxable income
- depreciation and CCA are often used interchangeably
Taxable Income
= revenues - expenses - CCA
Un-depreciated Capital Cost
the balance remaining in an asset class that has not yet been depreciated in that year
Half Year Rule
only one-half of the purchase cost of the asset is added to the asset class and used to compute CCA in the year of purchase enforced by gov
CCA Tax Shield
- tax savings arising from CCA
- generally has an infinite life
Method for computing CCA for intangible assets
straight-line
Method for computing CCA for asset classes
declining balance
When computing NPV…
we calculate the present value of the operating cash flow separately from the present value of the CCA tax shields
Marginal Corporate Tax Rate
the tax rate on the marginal or incremental dollar of pre-tax income
A negative tax is…
the same as a tax credit
Unlevered Net Income Formula
= net income + after-tax interest expense
Free Cash Flow
the incremental effect of a project on a firm’s available cash
