Chp 10: capital budgeting: estimating CF Flashcards
(106 cards)
1
Q
how do we estimate CF in capital budgeting?
A
We compute incremental cash flows from projects and compute the NPV of the incremental cash flows
2
Q
define incremental cash flow
A
cash flows (costs and revenues) that change because of the new production line
3
Q
what happens if incremental CFs have positive NPV
A
the value of the company is greater if it adopts the project and the change in the company’s value is equal to the NPV of the incremental cash flows
4
Q
3 ways capital equipment affects NPV
A
1) cash outflow at time 0
2) depreciation tax shield in each year
3) creates positive cash flow due to net salvage (bring to Present)
5
Q
what does UCC include?
A
purchase price and installation
6
Q
what do we need to remember when rent is per month for opportunity cost
A
make sure to multiply by 12.
7
Q
when can’t we use EAA?
A
when cash flows change for a project after replacement project
8
Q
what is CCA called?
A
capital cost allowance
9
Q
what is CCA’s system?
A
CRA’s system for calculating depreciation expenses for tax purposes
10
Q
CCA method
A
declining balance depreciation method and assigns assets to property classes where each property class has a different depreciation rate
11
Q
CCA asset class 1
A
buildings = 4% depreciation rate
12
Q
CCA asset class 8
A
furniture, appliance, tools = 20%
13
Q
CCA asset class 10
A
vehicles = 30%
14
Q
CCA asset class 38
A
power operating moveable equipment = 30%
15
Q
CCA asset class 43
A
machinery and equipment = 30%
16
Q
CCA asset class 52
A
computer hardware = 100%
17
Q
formula for annual depreciation expense t
A
depreciation rate * UCC t - 1
18
Q
define UCC
A
undepreciated capital cost at the end of the previous year (aka book value of the asset)
19
Q
formula for UCC
A
capital cost - accumulated depreciation
20
Q
define accumulated depreciation
A
sum of all depreciation expenses claimed for an asset
21
Q
what is UCC in year 0
A
capital cost of the asset
22
Q
define capital cost of asset
A
original cost of asset + shipping costs and any other costs associated with installing the asset
23
Q
what does CCA assume and what does this mean
A
CCA system assumes that all assets are purchased in the middle of the year so in the first year of an asset’s life, a company can only claim a half-year of depreciation (divide depreciation rate in 2)
24
Q
what 2 things creates a tax shield
A
depreciation and interest expense
25
why does depreciation and interest expense create a tax shield
they are tax deductible so it reduces taxes by an amount equal to the product of the expense and the corporate tax rate
26
what is the tax shield
The difference between if depreciation is and is not tax deductible
27
formula for operating cash flow
[EBITDA - depreciation](1-t) + depreciation since depreciation is a non-cash charge
28
formula for tax rate
taxes paid / earnings before taxes
29
what happens when an asset is sold?
proceeds from the sale are a positive cash flow
30
define salvage value and aka
resale value of an asset at the end of a project. Also called scrap value.
31
*** are proceeds from selling asset taxable?
no **
32
what happens if asset is sold for more than purchase price?
difference is taxable capital gain
33
what happens if salvage < UCC
then a residual amount is left in the pool and that residual generates a perpetual series of tax shields
34
formula for PV tax shield
tax rate * depreciation rate * (UCC (t) - Salvage) / (cost of capital + depreciation rate)
35
numerator of PV tax shield
tax shield in the year t +1 associated with the residual
36
why do we have negative growth rate for PV tax shield (+ depreciation rate)
because tax shield declines over time
37
what happens when salvage > UCC
When salvage > UCC, then the whole expression is negative and it takes away some UCC from other assets in the company. This reduces the tax shield that those assets would have generated.
38
formula for net salvage
Net salvage = salvage + PV tax shields
39
what happens if net salvage is less than salvage
PV of tax shields is negative so UCC is less than salvage value
40
formula for depreciation tax shield
depreciation expense * tax rate
41
formula for PV depreciation tax shield
depreciation tax shield / (1+WACC)^t
42
If net salvage is less than the salvage value of the asset, then we know that the undepreciated cost of the asset is the same as/greater than/less than the salvage value of the asset.
less than
43
2 ways projects are classified
expansion or replacement projects
44
define replacement projects
old asset is replaced by new asset
45
define expansion project
new project. There are no old costs and revenues to complicate analysis
46
what do almost all projects require?
ongoing capital investments throughout their operating lives
47
what does our analysis of projects include?
initial cash flow, annual operating CF, terminal CF
48
formula for initial cash flow
= - initial purchase price of new asset - installation/shipping cost of new asset - increase in net working capital (all of these components are subtracted because they represent cash outflows)
49
why does increase in NWC represent cash outflow?
means the company is buying more assets
50
formula for NWC
(current assets - cash) - (current liabilities - debt)
51
when might new asset result in reduction of NWC
if it allows for increased efficiency in inventory management (less assets)
52
2 things we assume for NWC
Realistically, net working capital is usually tied to sales and fluctuates with sales. Assume NWC is liquidated in the terminal year of the project which generates a positive cash flow.
53
define operating cash flow
revenues less costs and taxes. Also equal to net income plus interest and depreciation
54
when is project only accepted?
Only if PV cash inflows > PV of investment (NPV > 0)
55
what is NOPAT - formula and what it stands for
EBIT(1-t) is NOPAT - net operating profit after tax
56
what is EBITDA also called
gross profit
57
what do we do if depreciation is not tax deductible?
completely ignore it from OCF calculation
58
define terminal cash flows
cash flows spent (or received) in the final year of a project
59
formula for terminal cash flow
OCF + net salvage value + decrease in net working capital
60
what time period is terminal cash flow
last year of the OCF
61
True or False? If working capital increases in the terminal year, then that increase will reduce terminal year cash flows.
true
62
incremental cash flows associated with replacement formula
Cash flows with replacement - cash flows with keeping old equipment
63
what time is date of replacement
time 0
64
replacement: initial cash flow
- purchase price of new asset + salvage value of old asset - increase in NWC
65
CCA implications for when asset is replaced
When an asset is replaced, the CCA system adds the cost of the new machine to the asset class and deducts the salvage value of the old machine. This always increases the UCC balance in the class so there are no tax implications associated with purchase or sale at time of replacement. The tax implication is associated with CCA (depreciation)
66
replacement: incremental OCF
OCF after replacement - OCF with old asset = change in EBIT(1-t) + change in depreciation
67
replacement: what changes for pooled UCC asset class
For depreciation, salvage value of old asset is removed from pooled UCC of asset class and the capital cost of new asset is added
68
replacement: incremental capital cost
cost of new machine - salvage value of old machine
69
replacement: what is UCC at time 0
incremental capital cost
70
replacement: what is incremental depreciation expense
Incremental depreciation expense is the declining balance depreciation expense associated with the incremental capital cost
71
replacement: does half year rule apply?
yes
72
replacement: formula for incremental salvage
salvage value of new machine - salvage value of old had it been kept in service
73
replacement: formula for net incremental salvage
incremental salvage + PV incremental tax shields
74
what do we remember when OCF and terminal CF when calculating NPV?
do not include OCF in terminal year
75
6 rules to follow when estimating CF
1) aggressively seek and include indirect costs
2) disregard sunk cost
3) include opportunity cost
4) consider externalities
5) adjust for taxes
6) ignore financing costs
76
define indirect costs and give example
cost to a business that is not directly related to making the product/service; doesn’t affect the per unit cost of production. Example: insurance
77
define sunk costs
irreversible past costs
78
define opportunity cost
full cost of a choice, value of the best forsaken alternative
79
formula for opportunity cost
direct cost + indirect cost
80
define indirect cost with respect to opportunity cost and give 2 examples
value of assets used but not paid for
| time, land
81
define externalities
a cost (or benefit) that accrues to a 3rd person who is not a direct party to a transaction, a side effect
82
what are project externalities usually?
negative
83
do we include effect of sales on other companies in externalities?
no
84
what does ignoring financing costs mean and why do we do it?
Do not include interest cost in estimating cash flows. The financing decision is separate from capital budgeting decision.
85
what would happen if we were to include interest costs?
The NPV and IRR includes cost of funds by using discount rate that reflects required return. If we were to include interest expense, we would be double charging the project for financing.
86
why may a larger project have largest NPV
because it consumes company resources for a long time
87
which may have larger NPV: series of shorter projects or one long term project
series of shorter projects
88
what do both methods for comparing projects with unequal lives assume?
they both assume that when the short term project concludes another similar project will be available
89
2 methods for projects with unequal lives
1) replacement chain approach
| 2) equivalent annual annuity method
90
define replacement chain approach
involves repeating each project until a common length is achieved and then comparing the net present values of the 2 streams of cash flows
91
replacement chain approach: if project lasts for 5 years, when do add another initial investment?
at time 5
92
what does EAA avoid?
Avoids problem where lengths are not multiples of each other
93
define EAA
essentially the NPV per year. It is an annual dollar amount (for each year of a project’s life) that has a PV equal to the project’s NPV
94
what does EAA assume
Assumes both projects can be repeated forever
95
what are cash flows converted into in EAA and why
Cash flows converted into annuities which can be compared
96
rationale for EAA
firm is going concern in that similar substitute projects will be available
97
what happens if unusual projects are being evaluated with different lives?
neither approach is appropriate
98
steps for EAA
1) compute NPV for each project
2) find annuity payments that have the same PV as the NPV and the same number of periods as the project. (PV should be negative when solving for PMT)
3) EAA is the PMT
4) higher EAA is one to choose because it generates more NPV per year
99
3 problems with both EAA and replacement chain projects
1) Replacement similar jobs may not be available
2) Due to inflation, subsequent costs may be higher than initially projected
3) All errors with estimating cash flows are compounded when we assume CF repeat
100
why do we incorporate sensitivity analysis in NPV analysis?
To incorporate uncertainty into NPV analysis
101
define sensitivity analysis
series of analyses that reflect the effects of different assumptions
102
what does sensitivity analysis tell us
It tells use how sensitive the results are to changes in the estimates
103
steps for sensitivity analysis
1) prepare complete cash flow estimation schedule
2) compute NPV of cash flows
3) vary each uncertain estimate over its reasonable range and record resulting NPV from each change
4) graph results from 3
5) scenario analysis. Prepare additional evaluations by changing more than one input
104
define scenario analysis
group of assumptions are changed simultaneously to determine impact on project’s profitability. Assumptions are connected by a theme, typically boom and bust case (everything right and everything wrong)
105
sensitivity analysis graph using sales
NPV y axis, sales x axis, graphing NPV, the more steep the line, the more sensitive the NPV is to sales estimates
106
do we treat OC as pre-tax?
yes
