Corp Fin Lvl 2 - Reading 23 Capital Budgeting Flashcards
When is an analysis needed to make decision? replacement project to maintain bus, replacement for cost reduc, expansion proj?
replacement for cost reduction and a very detailed analysis is required for expansion projects
define opportunity costs (lvl 1 reminder)
“cash flows that a firm will lose by undertaking the project under analysis”
describe why timing of cash flows is important
“capital budgeting decisions account for TVM, therefore cash flows received earlier are worth more than later flows”
Formula: initial outlay
outlay = FCInv + NWCInv
Describe FCInv
“compenents are price, which includes shipping and installation”
Describe NWCInv
Investments in net working capital, includes the differences that will arise from needing more inventory or with a/p increasing
Definition for NWCInv
“the difference between changes in non-cash current assets & change in non-debt current liabilities”
When NCWInv is positive, is this a cash inflow or outflow?
cash outflow because “cash much be used to fund the net investment in current assets”
Formula for After-Tax operating cash flows (CF)
=(S-C-D)(1-T) +D or (S-C)(1-T) +(TD). you account for depreciation by “either adding it back to NI or by adding the tax savings caused by depreciation back to project’s after-tax profit (i.e. TD)”
FORMULA: Terminal year After-Tax non-operating cash flows (TNOCF)
Sal(sub T) + NWCInv -T(Sal(sub T) - B(sub T)
What is TNOCF?
Terminal year After-Tax non-operating cash flows - the cash inflows that occur at the end of the asset’s life
how do changes in inflation affect project profitability?
“if inflation is higher than expected, future project cash flows are worth less, and the value of the project will be lower than expected”
How does higher inflation affect depreciation tax savings?
inflation higher than expected –> depreciation tax shelter is less valuable and the real taxes are therefore increased
how does higher inflation affect payments to bondholders?
bondholders’ fixed payments are effectively worth less as inflation increases
What do you use (NPV or annuity payments) for the least common multiple of lives method?
NPV
What do you use (NPV or annuity payments) for the EAA (Equiv annual annuity approach)
annuity payments
DEFINE: capital rationing
“the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth”
DEFINE: hard capital rationing
“occurs when the funds allocated to managers under the capital budget cannot be increased.”
DEFINE: soft capital rationing
“occurs when managers are allowed to increase their allocated capital budget by convincing senior mgmt add’l fund will create shareholder wealth”
DEFINE: Sensitivity analysis
“changing an independent variable to see how sensitive depended variable is to input (aka independ. var)”
DEFINE: Scenario analysis
“risk analysis technique that considers both sensitivity of some key output variable to change in key input variable and likely probability of these variables
key difference between sensitivity and scenario analysis
“scenario analysis allows for changes in multiple input (independent) variables all at once”
If the project beta is low, and analyst uses WACC to determine required return, will it overstate or understate the required return?
will overstate the required return
DEFINE: real options in capital budgeting
“allow managers to make future decisions that change the value of capital budgeting decisions made today” - similar to puts and calls
DEFINE: timing options
“allow a comp to delay making an investment with hope of having better info in the future”
DEFINE: abandonment options
similar to put options - allows management to abbandon project if PV of exiting > PV of continuing
DEFINE: Expansion options
similar to call options. allows company to make add’l investments in proj if it creates value
DEFINE: Flexibility options
managers have choices for operational aspects of a proj (price setting or production flexibility)
DEFINE: Fundamental options
“payoffs depend on the price of an underlying assets” (e.x. opening a copper mine when copper prices are low - is that a good move for comp?)
Formula: economic income
Cash flow (After tax) + (ending MV-Beg MV)
or AT Cash flow + Change in MV
or cash flow - econ depreciation
DEFINE: accounting income
reported NI on company’s financial stmts that results from investment in a project
How do accounting income and economic income differ?
- depreciation - accounting dep is based on orig cost and not market value 2. financing costs - accounting subtracts interest expense and it is ignored in economic income because it is fully captured in WACC
Formula: Economic Profit
=NOPAT - $WACC
$WACC = WACCx capital (e.g. $ cost of investment)
DEFINE: MVA
market value added: NPV based on economic profit
Formula: MVA
=sum of (econ profit) / (1+WACC)^time
Formula: residual income
NI - equity charge (equity charge = required return on equity x BV of t-1)
Formula: equity charge
required return on equity x BV of t-1
Formula: NPV of investment using Residual income
RI / (t + required return on equity)^time (you are discounting the residual income at the rate of the required return)
The residual income approach focuses on on returns to a. management 2. equity holders?
- equity holders and that is why the required rate of return is appropriate
DEFINE: claims valuation approach
“divides operating cash flows based on the claims of debt and equity holders that provide capital to the company” *values the company, not the project
