Corporate Finance Flashcards
What is the mnemonic for Annual After Tax Operating Cash flow for new investment
All variables are the annual values, including Depreciation
She SuCkeD it Dry
CF=PV [ (S-C-D)(1-T)+D ]
SuCk 1T ToDay
CF=PV [ (S-C)(1-T)+TD]
What is the mnemonic for Annual After Tax Operating Cash flow for replacement projects
SuCk 1T ToDay and tomorrow
All variables including Dep are the annual values
PV [ ◇CF=(◇S-◇C)(1-T)+T◇D ]
Note:
its really just the Cash flow differences in “SuCk 1T ToDay” for the cashows from the replacement project vs the existing asset
◇S = annual (Snew-Sold)
◇C = annual (Cash expense new - Cash expense old)
◇D = annual (Dep new - Dep old)
Why is interest not included in capital budgeting operating cash flows
It’s included in the WACC of the project
Compare Initial investment components with TNOCF components for expansion
- Initial Investment (NewCastle Football Club) is a cash outflow:
(a) NWCInv, the increase in net non cash non debt working capital
(b) FCInv, fixed capital investment
-(a+b) = - ( + NWCInv + FCInv )
- Terminal non operating cash flow (TNOCF) is a salty cash inflow:
(a) after tax Salvage value, Sal, recovering part of the fixed capital investment, adjusted for tax on any gain or loss relative to the book value of the project assets,
=Sal - T (Sal-Book)
(b) recovering the non cash non debt working capital made at initial investment,
=NWCInv
(a+b) = Sal - T (Sal-Book) + NWCInv
Explain the three components of TNOCF for an expansion
Terminal non operating cash flow (TNOCF) is a salty cash inflow:
TNOCF = PV of
(a) Pre-tax Salvage value, Sal, recovering part of the fixed capital investment
(b) tax on any gain or loss on Salvage relative to the book value of the project assets
(c) recovery of the non cash non debt working capital made at initial investment, NWCInv
= PV [ (a) - (b) + (c)] = PV [ (Pre-tax Salvage) - (tax on gain or loss over book) + (recovery of working capital investment) ] = PV [ Sal - T (Sal-Book) + NWCInv]
How did operating cashflows by year suck in capital budgeting
What is the mnemonic
What are the line items by year
- They SuCkeD 1T Dry
- (S-C-D) (1-T) + D
- PV of annual cashflows of Line items:
Sales revenues
- Cash expenses
- Depreciation expenses
= EBIT
- Tax
= EBIT(1-T)
+ Depreciation
= After Tax CFO
State and interpret the mnemonic for operating cashflows by type in capital budgeting
What are the line items for CFO
- SuCk 1T ToDay
- PV of line items for each year
- Line items for CFO(a) Gross Profit After Tax. (S-C)(1-T)Plus(b) Depreciation Tax shield. T x D
Compare MACRS depreciation with straight line depreciation using 5 points
- Total depreciation expense for straight-line and MACRS is the same
- Tax saving for straight-line and MACRS is the same
However, for non zero discount rate
- PV MACRS depreciation expense is higher
- PV MACRS Depreciation Tax shield is higher
- Project NPV and IRR is higher with MACRS
What is the half-year convention
It assumes a project is placed in service in the middle of the year so 1st and last year represent 12 months
So a 3 year MACRS is depreciated over 4 years roughly
33%
45%
15%
7%
When does MACRS switch to straight line from double declining balance
When straight line depreciation >= double declining balance
What is DDB
Depreciation Year Z = 2 x SLD% x (book value Year Z-1 )
What are 6 categories of capital budgeting projects
What is the mnemonic
“More PR reduces maintenance costs”
Mandatory
Other
Replacement - cost reduction
Expansion
Product or market
Replacement - maintain
What are the 5 key principles of capital budgeting decisions
- Incremental Cash Flows not accounting income
- Opportunity costs must be included
- Timing of Cash flows
- After Tax cash flows
- Finance costs not included in cash flows
Explain why capital budgeting uses Incremental Cash Flows and not accounting income
The decision is based on if the project is undertaken or not undertaken.
Project choices may also be a new mutually exclusive project or replacement for cost reduction or business maintenance purposes
Accounting income could include:
Gains or losses on investments, Intangibles etc
Explain why Opportunity costs must be included in capital budgeting
For projects that are mutually exusive there is an Opportunity cost for not doing one vis a vis the project chosen
For projects that use an existing asset, there is an opportunity cost of using the asset for this project e. g. Land used for a new factory which could otherwise be rented
For replacement projects the differential cash flow reflects the opportunity cost of the replacement
Explain why Timing of Cash flows is important in capital budgeting
The time value of money means earlier cash flows are more valuable than later cash flows
Explain why After Tax cash flows is used in capital budgeting
The impact of taxes e. g. Sale of fixed assets vis a vis book value, and Depreciation Tax shield
Explain why Finance costs are not included in cash flows for capital budgeting
Interest is not part of CFO
The NPV uses a WACC that includes interest
Should cash flow from externalities be included in capital budget, why.
Give two examples
Yes, the choice to undertake the project generates the externality
Should sunk during a project evaluation decision be included. Why?
No.
Because whether the decision is to go ahead or not go ahead, the sunk costs are irrecoverable.
What is the initial outlay for an expansion project
- Initial Investment (NewCastle Football Club) is a cash outflow:
(a) NWCInv, the increase in net non cash non debt working capital
(b) FCInv, fixed capital investment, including shipping and installation
-(a+b) = - ( + NWCInv + FCInv )
What is the initial outlay for a replacement project
- Initial Investment (NewCastle Football Club) is a cash outflow:
(a) NWCInv, the increase in net non cash non debt working capital
- NWCInv
(b) FCInv, fixed capital investment including Shipping and Installation
- FCInv
(c) the outlay is reduced by the cash inflow from the after tax Salvage value of the old asset adjusted for gain over BV
\+ Sal old - T (Sal old - BV old)
-[NWCInv+FCInv - Sal old + T (Sal old - BV old)]
Explain the TNOCF for a replacement project
Terminal non operating cash flow (TNOCF) is a salty cash inflow:
=PV of [ (Pre-tax Salvage new - old) - (tax on gain or loss over book for both new and old assets) + (recovery of working capital investment) ]
= PV of [ (Sal new - Sal old)
- T (Sal new-Book new) - T (Sal old-Book old)
\+ NWCInv ]
Contrast initial outlay and depreciation for expansion and replacement
For expansion outlay:
Fixed capital + noncash no debt working capital
For replacement outlay:
(Fixed capital new) - (after Tax Salvage value old)
For DEPRECIATION:
Expansion = D
Replacement = (D new - D old)
Give two ways to compare mutually exclusive projects with unequal lives
Why do we have to do this
- The replacement chain approach
- The equivalent annuity approach
Because a longer lived project may have a higher NPV but lower IRR
- What is sensitivity analysis?
- Explain how this assesses the standalone risk of a project
- Changing one variable while holding others constant.
- Involves (i) changing one variable a fixed percentage above and below base case such as sales volume, sales price, input cost, or the assumed cost of capital, and (ii) recalculating the NPV.
- The project with the greater percentage change in NPV for a given variable change is the riskier project.
- What is scenario analysis
- How is this used to assess standalone risk of a project?
- Applying different values to multiple variables based on worst case, base case and best case, assign probabilities to each scenario and a dustribution of NPV and IRR.
- (i) Calculate the NPV for “base-case,” worst-case (low sales, low price, etc.), and a best-case scenario.
(ii) Assign probabilities to each of these outcomes.
(iii) Then calculate the standard deviation of the NPV as you would with any probability model.
- What is monte carlo simulation?
- How can this ve used to assess the standalone risk of a project?
- A simulation analysis that generates a probability distribution of project NPV outcomes.
- Use the distribution of NPVs to estimate the expected NPV and the standard deviation of NPV as a measure of stand-alone project risk.
What are the constraints of an unlimited investment budget
Continue to invest in positive return NPV projects until the marginal returns equal the marginal cost of capital.
What are the 3 steps for a montecarlo analysis
- Use assumed probability distributions for the key variables in the NPV calculation.
- Randomly draw values from the distribution for these input variables.
- calculate NPV (thousands of times) from these drawn values of variables.
What does the EAA approach to project evaluation assume
Replacements can and will be made at the end of each asset life
Define after tax operating cash flow
= EBIT(1-T) + Dep
= NOPAT + Dep
What is incremental cash flow
The cashflow resulting from a decision.
Incremental CF= (CF Choice A) - (CF Choice B)
Name two types of externalities, provide one example of each
- Positive and Negative
- Positive - a new product line increases sales of exusting products
- Negative - sales of a new product cannabilise sales of existing product
Name two types of externalities, provide one example of each
- Positive and Negative
- Positive - a new product line increases sales of exusting products
- Negative - sales of a new product cannabilise sales of existing product
Why are after tax cash flows important for NPV
Valuation of a firm is based on cash flows it keeps not cash flow it sends to government
Which rates and cash flows have already been adjusted for inflation
Real rates and real CFs
What 3 things does inflation affect
- Real rates and real cash flows
- NPV
- Real value of Tax shelter
Describe real discount rate in nominal terms
Give an example if i=5÷, nom=6%
(1+Real)=(1+nominal)/(1+inf)
Real rate = 6-5 = 1
Why is NPV a better selection metric tfan IRR
IRR has less realistic reinvestment assumptions.
NPV has no reinvestment assumptions.
For high project Rs, IRR is more valid if it is
(A) much higher
(B) a little higher
A because of the reinvestment rate assumption which overstates probable realised return
Explain the concept of claims valuation
- Separates cash flows of an asset into equity and debt components.
- Cash flows to debt holders are discounted at the cost of debt.
- Cashflows to equity are discounted at cost of equity.
- The present value of each set of cash flows is added together to determine the value of the firm.
What is MVA?
How is it calculated?
Market Value Added
- NPV of all future Economic Profits
- Discounted by WACC
What is the discount rate for MVA
Returns to all suppliers of capital.
Example if firms debt and equity holders provide all the capital it is the WACC
Describe the EAA approach
- Compares mutually exclusive projects in a replacement chain.
- Assumes company assets will be replaced as they wear out
What is IRR
Discount rate which sets NPV=0
