Corporate Finance - Chp. 21: Capital Budgeting

Question 1

• Principles of capital budgeting

Answer 1

• Decisions based on cash flows, not accounting income, specifically incremental cash flows
• 2. Cash flows based on opportunity costs – cash flows a firm will lose by undertaking a project
• 3. Timing of cash flows important
• 4. Cash flows analyzed on an after tax basis
• 5. Financing costs reflected in project’s required rate of return

Question 2

3 types of cash flows for capital projects

Answer 2

1. initial investment outlay
2. after tax operating cash flows
3. terminal year after tax non-operating cash flows

Question 3

initial investment outlay equations

Answer 3

• outlay = FCInv + NWCIn
  
  • FCInv = price with shipping and handling
  • NWCinv = investment in net working capital
• NWCInv = Δnon-cash current assets – Δnon-debt current liabilities = ΔNWC
  
  • defined as the difference b/t the changes in non-cash current assets and changes in non-cash current liabilities
  • if (+), additional financing required and represents cash outflow
  • if (-), project frees up cash creating cash inflow

Question 4

After tax operating cash flows (CF)

Answer 4

• incremental cash inflows over capital asset’s economic life
• CF = (S – C – D)(1 – T) + D = (S – C)(1 – T) + (TD)
  • S = sales

C = cash operating costs

D = depreciation expense

T = marginal tax rate

*

Question 5

Terminal year after-tax non-operating cash flows

Answer 5

• At the end of the asset’s life, there are certain cash inflows that occur. These are the after-tax salvage value and the return of the net working capital.
• TNOCF = SalT + NWCInv – T (SalT – BT)
  
  • SalT = pre-tax cash proceeds from sale of fixed capital

BT = book value of the fixed capital sol

Question 6

Replacement project analysis

Answer 6

• 1. Reflect the sale of old asset in calculation of initial outlay
     * outlay = FCInv + NWCInv – Sal₀ + T (Sal₀ – B₀)
• 2. Calculate the incremental operating cash flows as the cash flows from the new asset minus the cash flows from the old
     * ΔCF = (ΔS – ΔC)(1 – T) + ΔDT
• 3. Compute the terminal year non-operating cash flow
     * TNOCF = (SalTNew – SalTOld) + NWCInv – T[(SalTNew – BTNew) – (SalTOld – BTOld)]

Question 7

5 ways inflation affects capital budgeting process

Answer 7

1. Analyzing nominal or real cash flows.
2. Changes in inflation affect project profitability.
3. Inflation reduces the tax savings from depreciation.
4. Inflation decreases the value of payments to bondholders
5. Inflation may affect revenues and costs differently

Question 8

2 ways to compare mutually exclusive projects with different lives

Answer 8

1. least common multiple of loves approach
2. equivalent annual annuity approach

Question 9

How to do least common multiple of lives approach

Answer 9

Compare as many repetitions of an project it takes to get to the same amount of life as the otehr project option

Ex. compare back to back 3 yr options to a single 6 year option

Question 10

Equivalent annual annuity approach to comparing mutually exclusive projects

Answer 10

1. Find each projects NPV
2. find an annuity that equals the PV of the project’s npv at the WACC
3. select project with highest EAA

Question 11

Capital rationing

Answer 11

allocation of fixed amount of capital among best available projects to maximize total value

Question 12

Sensitivity analysis

Answer 12

changing an input variable (by fixed %) to see how sensitive dependent variable is to the input

Question 13

Scenario analysis

Answer 13

considers sensitivity of output variables (NPV) to changes in inputs and the probability distribution of those inputs.

• Can change multiple inputs at once
• Run best case, base case, worst case scenarios

Question 14

Simulation analysis (Monte Carlo)

Answer 14

• – results in probability distribution of project NPV outcomes
  
  • . Assume probability distribution for each input variable
  • 2. Simulate random draw from distribution of each input
  • 3. Calculate project NPV
  • 4. Repeat steps 2&3 10,000 ties
  • 5. Calculate mean NPV, SD of NPV, and correlation of NPV with each input
  • 6. Graph probability distribution of NPV results

Question 15

Security market line (SML) for capital asset pricing model (CAPM

Answer 15

• – defines projects required rate of return considering risk
  
  • Rproject = RF + βproject [E(RMKT) - RF]
    
    • RF = risk-free rate

βproject = project beta

E(RMKT) – RF = market risk premium

Question 16

Real options (5)

Answer 16

• Timing options – delay an investment to have better info in the future
• Abandonment options – similar to put options. Allow management to abandon a project if CF from exiting is better than cash flow from continuing
• Expansion options – Similar to call options. Allows making additional investment if doing so creates more value
• Flexibility options – choices regarding the operational aspects of projects
  
  • Price-setting: allows changing price of product
  • Production flexibility: paying workers overtime, making product variety
• Fundamental options – projects are an option depending on price of asset (e. oil price)

Question 17

• Assessing value of real options

Answer 17

• overall NPV = project NPV (based on DCF) – option cost + option value

Question 18

• Common capital budgeting pitfalls

Answer 18

• Failing to incorporate economic response into analysis
• Misusing standardized templates
• Pet projects of senior a management
• Basing investment decision on EPS or ROE
• Using the IRR criterion for project decisions
• Poor cash flow estimation
• Misestimation of overhead costs
• Using incorrect discount rate
• Politics involved with spending the entire capital budget
• Failure to generate alternative investment ideas
• Improper handling of sunk and opportunity costs

Question 19

Economic income

Answer 19

after tax cash flow plus the change in the investments market value

economic income = cash flow + (ending market value – beginning market value)

or

economic income = cash flow – economic depreciation

where:

economic depreciation = (beginning market value – ending market value)

Question 20

Accounting income

Answer 20

• reported net income on a company’s financial statements from project
  
  • Different from economic income due to:
    
    • Accounting depreciation is based on original cost
    • Financing costs are considered a separate line item and subtracted out to arrive at net income

Question 21

Economic profit

Answer 21

measure of profit in excess of the dollar cost of capital invested in project

EP = NOPAT – $WACC

where:

NOPAT = net operating profit after tax = EBIT (1 – tax rate)

$WACC = dollar cost of capital = WACC × capital

Capital = dollar amount of investment

Question 22

Market Value Added

Answer 22

• npv based on economic profit
• WACC used for discount rate
• Company value is project NPV plus initial investment

Question 23

Residual income

Answer 23

Calculates value of project and company. focuses on returns on equity

residual income = net income – equity charge

RIt = NIt - reBt-1

where:

RIt = residual income in period t

NIt = net income in period t

re = required return on equity

Bt–1 = beginning of period book value of equity

• Like other capital budgeting methods, discounting the residual income at the required rate of return on equity will give the NPV of the investment
• Discount rate is required rate of return on equity

Question 24

Claims valuation approach

Answer 24

• divides operating cash flow based on claims of debt and equity holders that provide capital.
  
  • cash flows to debtholders consist of interest and principal payments and are discounted at the cost of debt
  • cash flows to equity holders are dividends and share repurchases and are discounted at the cost of equity
  • Sum of PV’s of each stream will equal value of the company