Corp Fin Lvl 2 - Reading 23 Capital Budgeting

Question 1

When is an analysis needed to make decision? replacement project to maintain bus, replacement for cost reduc, expansion proj?

Answer 1

replacement for cost reduction and a very detailed analysis is required for expansion projects

Question 2

define opportunity costs (lvl 1 reminder)

Answer 2

“cash flows that a firm will lose by undertaking the project under analysis”

Question 3

describe why timing of cash flows is important

Answer 3

“capital budgeting decisions account for TVM, therefore cash flows received earlier are worth more than later flows”

Question 4

Formula: initial outlay

Answer 4

outlay = FCInv + NWCInv

Question 5

Describe FCInv

Answer 5

“compenents are price, which includes shipping and installation”

Question 6

Describe NWCInv

Answer 6

Investments in net working capital, includes the differences that will arise from needing more inventory or with a/p increasing

Question 7

Definition for NWCInv

Answer 7

“the difference between changes in non-cash current assets & change in non-debt current liabilities”

Question 8

When NCWInv is positive, is this a cash inflow or outflow?

Answer 8

cash outflow because “cash much be used to fund the net investment in current assets”

Question 9

Formula for After-Tax operating cash flows (CF)

Answer 9

=(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)”

Question 10

FORMULA: Terminal year After-Tax non-operating cash flows (TNOCF)

Answer 10

Sal(sub T) + NWCInv -T(Sal(sub T) - B(sub T)

Question 11

What is TNOCF?

Answer 11

Terminal year After-Tax non-operating cash flows - the cash inflows that occur at the end of the asset’s life

Question 12

how do changes in inflation affect project profitability?

Answer 12

“if inflation is higher than expected, future project cash flows are worth less, and the value of the project will be lower than expected”

Question 13

How does higher inflation affect depreciation tax savings?

Answer 13

inflation higher than expected –> depreciation tax shelter is less valuable and the real taxes are therefore increased

Question 14

how does higher inflation affect payments to bondholders?

Answer 14

bondholders’ fixed payments are effectively worth less as inflation increases

Question 15

What do you use (NPV or annuity payments) for the least common multiple of lives method?

Answer 15

NPV

Question 16

What do you use (NPV or annuity payments) for the EAA (Equiv annual annuity approach)

Answer 16

annuity payments

Question 17

DEFINE: capital rationing

Answer 17

“the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth”

Question 18

DEFINE: hard capital rationing

Answer 18

“occurs when the funds allocated to managers under the capital budget cannot be increased.”

Question 19

DEFINE: soft capital rationing

Answer 19

“occurs when managers are allowed to increase their allocated capital budget by convincing senior mgmt add’l fund will create shareholder wealth”

Question 20

DEFINE: Sensitivity analysis

Answer 20

“changing an independent variable to see how sensitive depended variable is to input (aka independ. var)”

Question 21

DEFINE: Scenario analysis

Answer 21

“risk analysis technique that considers both sensitivity of some key output variable to change in key input variable and likely probability of these variables

Question 22

key difference between sensitivity and scenario analysis

Answer 22

“scenario analysis allows for changes in multiple input (independent) variables all at once”

Question 23

If the project beta is low, and analyst uses WACC to determine required return, will it overstate or understate the required return?

Answer 23

will overstate the required return

Question 24

DEFINE: real options in capital budgeting

Answer 24

“allow managers to make future decisions that change the value of capital budgeting decisions made today” - similar to puts and calls

Question 25

DEFINE: timing options

Answer 25

“allow a comp to delay making an investment with hope of having better info in the future”

Question 26

DEFINE: abandonment options

Answer 26

similar to put options - allows management to abbandon project if PV of exiting > PV of continuing

Question 27

DEFINE: Expansion options

Answer 27

similar to call options. allows company to make add’l investments in proj if it creates value

Question 28

DEFINE: Flexibility options

Answer 28

managers have choices for operational aspects of a proj (price setting or production flexibility)

Question 29

DEFINE: Fundamental options

Answer 29

“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?)

Question 30

Formula: economic income

Answer 30

Cash flow (After tax) + (ending MV-Beg MV)
or AT Cash flow + Change in MV
or cash flow - econ depreciation

Question 31

DEFINE: accounting income

Answer 31

reported NI on company’s financial stmts that results from investment in a project

Question 32

How do accounting income and economic income differ?

Answer 32

1. 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

Question 33

Formula: Economic Profit

Answer 33

=NOPAT - $WACC

$WACC = WACCx capital (e.g. $ cost of investment)

Question 34

DEFINE: MVA

Answer 34

market value added: NPV based on economic profit

Question 35

Formula: MVA

Answer 35

=sum of (econ profit) / (1+WACC)^time

Question 36

Formula: residual income

Answer 36

NI - equity charge (equity charge = required return on equity x BV of t-1)

Question 37

Formula: equity charge

Answer 37

required return on equity x BV of t-1

Question 38

Formula: NPV of investment using Residual income

Answer 38

RI / (t + required return on equity)^time (you are discounting the residual income at the rate of the required return)

Question 39

The residual income approach focuses on on returns to a. management 2. equity holders?

Answer 39

2. equity holders and that is why the required rate of return is appropriate

Question 40

DEFINE: claims valuation approach

Answer 40

“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