Corporate Finance - R19 - Capital Budgeting Flashcards
a. calculate the yearly cash flows of expansion and replacement capital projects and evaluate how the choice of depreciation method affects those cash flows;
For an expansion project:
Initial outlay = FCInv + WCInv
CF = (S − C − D)(1 − T) + D = (S − C)(1 − T) + DT
TNOCF = SalT + NWCInv − T(SalT − BT)
For a replacement project, the cash flows are the same as the previous except:
Current after-tax salvage value of the old assets reduces the initial outlay.
Depreciation is the change in depreciation if the project is accepted compared to the depreciation on the old machine.
Depreciation schedules affect capital budgeting decisions because they affect after-tax cash flows. In general, accelerated depreciation methods lead to higher after-tax cash flows and a higher project NPV.
b. explain how inflation affects capital budgeting analysis;
Inflation is a complication that must be considered as part of the capital budgeting process:
Nominal cash flows must be discounted at the nominal interest rate, and real cash flows must be discounted at the real interest rate.
Unexpected changes in inflation affect project profitability.
Inflation reduces the real tax savings from depreciation.
Inflation decreases the value of fixed payments to bondholders.
Inflation affects costs and revenues differently.
c. evaluate capital projects and determine the optimal capital project in situations of 1) mutually exclusive projects with unequal lives, using either the least common multiple of lives approach or the equivalent annual annuity approach, and 2) capital rationing;
There are two methods to compare projects with unequal lives that are expected to be repeated indefinitely:
The least common multiple of lives approach extends the lives of the projects so that the lives divide equally into the chosen time horizon. It is assumed that the projects are repeated over the time horizon, and the NPV over this horizon is used as the decision criterion.
The equivalent annual annuity of each project is the annuity payment each project year that has a present value (discounted at the WACC) equal to the NPV of the project.
Capital rationing is the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth. A firm with less capital than profitable (positive NPV) projects should choose the combination of projects it can afford to fund that has the greatest total NPV.
d. explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the stand-alone risk of a capital project;
Risk analysis techniques include:
Sensitivity analysis involves varying an independent variable to see how much the dependent variable changes, all other things held constant.
Scenario analysis considers the sensitivity of the dependent variable to simultaneous changes in all of the independent variables.
Simulation analysis uses repeated random draws from the assumed probability distributions of each input variable to generate a simulated distribution of NPV.
e. explain and calculate the discount rate, based on market risk methods, to use in valuing a capital project;
The CAPM can be used to determine the appropriate discount rate for a project based on risk. The project beta, β, is used as a measure of the systematic risk of the project, and the security market line (SML) estimates the required return as:
Rproject = Rf + βproject[E(RM) − Rf]
f. describe types of real options and evaluate a capital project using real options;
Real options allow managers to make future decisions that change the value of capital budgeting decisions made today.
Timing options allow a company to delay making an investment.
Abandonment options allow management to abandon a project if the PV of the incremental CFs from exiting a project exceeds the PV value of the incremental CFs from continuing a project.
Expansion options allow a company to make additional investments in a project if doing so creates value.
Flexibility options give managers choices regarding the operational aspects of a project. The two main forms are price-setting and production flexibility options.
Fundamental options are projects that are options themselves because the payoffs depend on the price of an underlying asset.
Approaches to evaluating a capital project using real options include: determining the NPV of the project without the option; calculating the project NPV without the option and adding the estimated value of the real option; using decision trees; and using option pricing models.
g. describe common capital budgeting pitfalls;
Common mistakes in the capital budgeting process include:
Failing to incorporate economic responses into the analysis.
Misusing standardized project evaluation templates.
Having overly optimistic assumptions for pet projects of senior management.
Basing long-term investment decisions on short-term EPS or ROE considerations.
Using the IRR criterion for project decisions.
Poor cash flow estimation.
Misestimation of overhead costs.
Using a discount rate that does not accurately reflect the project’s risk.
Politics involved with spending the entire capital budget.
Failure to generate alternative investment ideas.
Improper handling of sunk and opportunity costs.
h. calculate and interpret accounting income and economic income in the context of capital budgeting;
Economic income is equal to the after-tax cash flow plus the change in the project’s market value. Accounting income is equal to the revenues minus costs of the project.
There are two key factors that account for the differences between economic and accounting income:
Accounting depreciation is based on the original cost of the investment, while economic depreciation is based on the change in market value of the investment.
The after-tax cost of debt (interest expense) is subtracted from net income, while financing costs for determining economic income are reflected in the discount rate.
i. distinguish among the economic profit, residual income, and claims valuation models for capital budgeting and evaluate a capital project using each.
Alternative forms of determining income should theoretically lead to the same calculated NPV if applied correctly.
Economic profit is calculated as NOPAT − $WACC. Economic profit reflects the income earned by all capital holders and is therefore discounted at the WACC to determine the market value added (MVA) or NPV of the investment.
Residual income is focused on returns to equity holders and is calculated as net income − equity charge. Residual income reflects the income to equity holders only and is discounted at the required return on equity to determine NPV.
Claims valuation separates cash flows based on the claims that equity holders and debt holders have on the asset. Cash flows to debt holders are discounted at the cost of debt and cash flows to equity holders are discounted at the cost of equity. The present value of each set of cash flows is added together to determine the value of the company.
