Corporate Finance: Capital Budgeting

Question 1

Cash Flows Table Format (expansion project)

Answer 1

1. Year 0: FC Inv + WC Inv
2. Year 1-5: After tax operating cash flows
3. Terminal year: after tax FA sales + Return of WC Inv (year 5 can be a terminal year. Step three is added to the total after tax cash flow)

Question 2

Compute after-tax operating cash flow

Answer 2

+ Sales
- Operating expenses
- Depreciation
= Operating income before taxes
- taxes on operating income
= Op income after taxes
+ Depreciation
= After-tax operating cash flow

Question 3

After-tax Salvage Value

Answer 3

= (Sale price of FA) - [(Gain on FA) X (Tax rate)]

Question 4

MACRS

Answer 4

Modified Accelerated Cost Recovery System

Question 5

When does MACRS switch to straight line method?

Answer 5

• when the straight line amount would be at least as much as under the double or 150%(15 yr - 30 yr MACRS) method.

Question 6

Calculate MACRS annual depreciation

Answer 6

1. Determine double or 150% (over 15 yrs is 150%)
2. Assume asset has been used for 6 months in first year
3. Divide 1st year Dep % by 2 (5 years = 40%/2 = 20%)
4. Multiply each year’s beg BV by double/150%
5. Switch to straightline when optimal

Question 7

Depreciation Tax Savings

Answer 7

= Depreciation Exp. X Tax Rate

Question 8

Three steps of evaluating a replacement project

Answer 8

1. Investment outlays
2. Change in annual after-tax operating cash flows
3. Terminal year after-tax non-operating cash flow

Question 9

Investment Outlay Calculation (Replacement Project)

Answer 9

+FC Investment

+NWCInvestment (

-Sale of old equipment

+Taxrate(gain on sale of old equipment)

Investment Outlay

- Remember to use book value (less accumulated depr)

Question 10

Annual After-tax Operating Cash Flow (Replacement Project)

Answer 10

= (ΔSales-ΔCosts)(1-t)+ΔtD

• • ΔtD is the change in the depreciation tax shield*
• • You are only concerned about the change in cash flows*

Question 11

Terminal year after-tax non-operating cash flow (Replacement Project)

Answer 11

TNOCF =

+ Difference on sale of new/old equip
+ Return of additional WC
- Incremental flow from taxes on disposal

= TNOCF

- incremental flow from taxes are calculated like this example… .4(600K - BV) - .4(125K - BV)

Question 12

Methods to compare projects with unequal lives

Answer 12

1. Least common multiple of lives
2. Equivalent annual annuity approach
   * - If this is a one-shot project vs. investment chain, the project with the greatest NPV should be chosen.*

Question 13

Equivalent Annual Annuity Approach (EAA)

Answer 13

Comput the payment as if the project was an annual annuity

1. PV = negative NPV
2. FV = 0
3. N = Project life
4. Cpt Payment
   * - This may be superior to the common lifespan method*

Question 14

Profitability Index & Capital Rationing

Answer 14

• Hard or soft capital rationing means you can’t invest in everything and must prioritize
• PI = PV of Cash Flows / Initial investment

Question 15

3 Methods to Evalutate Standalone Risk

Answer 15

1. Sensitivity analysis: How much does NPV change for a change in one variable.
2. Scenario analysis: Each scenario tests the impact of probable scenarios across multiple variables.
3. Simulation/Monte Carlo analysis: Define probability distributions for each variable

Question 16

SML for CAPM to determine appropriate discount rate.

Answer 16

SML or Ri = Rf + β(Rm-Rf)

Question 17

Types of Real Options

Answer 17

• Timing Options: Can the company delay?
• Sizing Options: Can company abandon or expand project?
• Flexibility Options: Can prices be changed and can output quantities be changed?
• Fundamental Options: Options intrinsic to the project

Question 18

Price a project option (sizing example)

Answer 18

1. Weight the project according to probable outcomes and calculate NPV
2. Calcuate the NPV and weight it based on the probable outcomes from the time the option is “exercisable”.
3. Compare the difference between the value of 1 to the value of 2 to determine the value of the option.

Question 19

Economic income / ΔMarket Value / Economic Rate of Return

Answer 19

EI = After tax operating cash flow - change in Market Value

ΔMV = NPV of future cash flows at beginning of period - NPV of future cash flows at end of period. Each year’s ending MV = the nex year’s beginning MV

ERR = EI / Beginning MV

Question 20

Accounting Income

Answer 20

1. Includes interest expense (rather than just assuming it is embedded in the discount rate)
2. Is net income so depreciation is not added back

Question 21

Economic Profit Definition

Answer 21

1. What the company has after debt and equity holders are paid required rate of return.
2. Economic Profit = NOPAT - $WACC
   - NOPAT = Net operating profit after tax (does not include interest) EBIT(1-Tr)
   - $WACC = invested capital each year (BV of assets) X Required rate of return or cost of capital

Question 22

NPV of Economic Profit

Answer 22

= NPV of each year’s EP + Initial Capital Investment

Question 23

Residual Income / Equity Charge for Period

Answer 23

RI = Net Income for Period - Equity Charge for Period

ECfP = (Required return on equity) X (Beginning BV of Equity)

Question 24

Required Return on Equity

Answer 24

Cost of Capital(WACC) = WoD(CoD)(1-Tr) + WoE(Re)

• -WoD: Weight of Debt*
• • CoD: Cost of Debt (interest rate)*
• • WoE: Weight of Equity*
• Remeber that WACC formula may also include preferred or other types of equity/debt*

Question 25

Total project value based on Residual Income

Answer 25

= equity investment + debt investment + NPV of residual income

• The investment is equal to the initial capital (this may be split between debt and equity)

Question 26

Claims Valuation

Answer 26

1. Discounted NPV of payments to debt and equity holders
2. Debt is discounted based on the cost of debt
3. Equity is discounted based on the Re of equity

Question 27

Steps to calculate Claims Valuation

Answer 27

1. Calculate interest payments: Interest expense (accounting income)
2. Calculate principle repayment:
3. Calculated equity distributions:
4. Discount debt payments at cost of debt and equity payments at Re

Payments to shareholders are the net excess of after tax cash flows after debt payments.

Question 28

Calculate Equity Payments for Claims Valuation

Answer 28

+ Net income
+Depreciation expense
- Debt principle payments
Equity Payments

Question 29

Equity Distributions

Answer 29

+ Net Income

+ Depreciation

- Principle payments to debt

= Equity Distributions