Finance Flashcards
Capital Budgeting –
Buy vs. Lease
Finance
Core – Level B
Capital Budgeting – Buy vs. Lease (Finance)
• Calculate NPV of each option and compare to determine which option is cheapest
• NPV of buy option – consider:
o Cost of asset
o PV of tax shield
o Maintenance costs
• NPV of lease option – consider:
o PV of after tax lease payments
• Other factors to consider:
o Impact on covenants
o Cash flows (leasing lessens the current cash burden)
o Leasing may be easier to come by if company has trouble obtaining financing
o Purchasing the asset might provide more flexibility (ownership of asset)
o Leasing might insulate company from severe declines in asset value
o Possible tax advantages (no capital leases for tax purposes – CRA sees all leases the same so cash payments would be deductible, however no CCA)
Case: CHHP
Financing Options –
Debt vs. Equity
Finance
Core – Level B
Financing Options – Debt vs. Equity (Finance)
• Debt financing options:
o Loan- consider loan term, and security/collateral required
o Lease
o Government assistance
• Equity financing options:
o Angel investors- can be friends or family looking for a return on investment; generally passive investors
o Venture capitalists- professional investment funds, looking for superior returns (>30%); active participants in management, with a clear exit strategy
o Private equity- tends to participate later in business lifecycle, hence lower risk
o Public markets
Case: Ferguson Real Estate, World Wide Windows
Incremental Cash Flows
Finance
Core – Level B
Incremental Cash Flows (Finance)
• Incremental cash flows comprise the additional cash flows from taking on a new project, incorporating the tax-affected initial outlay, annual revenues & expenses and terminal value (or cost) associated with the project, in accordance with the scale and timing of the project
• When determining incremental cash flows from a new project, consider:
o Sunk Costs – These are the initial outlays that cannot be recovered even if a project is accepted. As such, these costs will not affect the future cash flows of the project and are not considered incremental
o Opportunity Costs – These represent any potential loss of current cash flows due to accepting a new project and are considered incremental
o Cannibalization – This is the opportunity cost where a new project takes sales away from an existing product
o Working Capital Changes – These represent changes in receivables, payables and inventory due to accepting a new project and are therefore considered incremental
Case: TankCo, Solar Panel Solutions, King Street Theatre
Net Present Value (NPV) vs. Internal Rate of Return (IRR)
Finance
Core – Level B
Net Present Value (NPV) vs. Internal Rate of Return (IRR) (Finance)
• The NPV rule states that you invest in any project which has a positive NPV when its cash flows are discounted at the opportunity cost of capital, also known as the discount rate (usually the cost of raising the capital to fund the project)
• The IRR rule states that you invest in any project offering a rate of return which exceeds the opportunity cost of capital
• A project’s rate of return is calculated as the discount rate at which the NPV of the project would be zero
• Therefore, the NPV and IRR rules should give the same accept/reject answer about a project, in most circumstances
• A project’s cash flows should include incremental elements only (i.e. additional sales, associated expenses, lost margin on cannibalization, investment & associated tax-shield, etc., but no financing elements, as discounting of the cash flows already addresses financing)
Discounted vs. Undiscounted
Cash Flows
Finance
Core – Level B
Discounted vs. Undiscounted Cash Flows (Finance)
• Incremental cash flows (excluding financing elements) should be discounted to recognize the time value of money for the purposes of making a decision regarding accepting or rejecting a project
• Incremental cash flows (including financing elements) should be analyzed year over year, without discounting, to determine if a certain cash position would be met by a certain time
Case: TankCo, Ferguson Real Estate, Elder Care Centre and Spa, Solar Panel Solutions
Payback Period
Finance
Core – Level B
Payback Period (Finance)
• Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment
• In general, investments with lower payback period are preferred
• To determine, calculate the cumulative net cash flow for each period and then use the following formula for payback period:
Payback Period = A + B / C, where:
o A is the last period with a negative cumulative cash flow;
o B is the absolute value of cumulative cash flow at the end of the period A; and
o C is the total cash flow during the period after A.
Financial Ratio Analysis
Finance
Core – Level A
Financial Ratio Analysis
Financial ratios are categorized according to the financial aspect that the ratio measures:
• Liquidity ratios measure the availability of cash to pay short-term debts.
E.g., Current ratio, Quick ratio, Working capital ratio
• Asset turnover ratios measure efficiency in utilizing assets. E.g., accounts receivable turnover, inventory turnover
• Profitability ratios measure how well assets are used and expenses are controlled to generate a return. E.g., gross profit margin, net profit
• Debt service ratios measure the ability to repay long-term debt. E.g., debt to equity, times interest earned
Ratios generally are not useful unless they are benchmarked against something else such as past performance or another organization. Therefore, the ratios of organizations in different industries, which face different risks, capital requirements, and competition, are usually hard to compare.
Case: Atlantic Shellfish, TankCo, Ferguson Real Estate, World Wide Windows, Solar Panel Solutions
Contribution margin
Finance
Core – Level B
Contribution margin (Finance)
• Contribution margin (CM) is the determination of how much variable profit is available to cover fixed costs and generate a profit.
• In general, the higher CM, the better.
• To determine CM, calculate the variable revenues per unit (hour, day, year, quantity) offset by the variable costs of the same.
• CM is A – B where:
A is the total variable revenue per unit;
B is the total variable expenses per unit.
Case: Lake Country Camping
Break-even analysis
Finance
Core – Level B
Break-even analysis (Finance)
• Break-even is the determination of sales volumes necessary to generate a zero-profit.
• Break-even can be expressed in number of units, total revenues, or a percentage of expected revenues.
• To determine, calculate the fixed costs per period, and divide them by the contribution margin (CM) per unit, to determine the necessary sales volumes to generate zero-profit.
• Break-even is A / B where:
A is the total fixed costs;
B is the CM per unit.
Business valuation – Asset-based approach
Finance
Core – Level B; Elective – Level A
Business valuation – Asset-based valuation approach
• To decide which valuation approach to apply, we must first determine whether the entity is a going concern.
• If the entity is NOT a going concern, a Liquidation approach must be used
o Net realizable value will depend upon whether or not there is a “forced” sale, or orderly liquidation
• If the entity IS a going concern, and the entity does not maintain active operations, the Adjusted Net asset approach may be appropriate
o Assets are valued at fair market value, net of disposition and tax costs
o Liabilities are paid
Case: TankCo, Ferguson Real Estate
Business valuation – Income-based approach
Finance
Core – Level B; Elective – Level B
Business valuation – Income-based approach
• If the entity IS a going concern, and the entity maintains active operations and “excess earnings”, an income-based valuation approach may be appropriate
• Capitalized cash flow approach- where the entity has consistent cash flows that are reflective of future earnings considering:
o Maintainable (normalized) EBITDA
o Sustaining capital reinvestments
o Capitalization rate/multiplier
o Income tax shield
o Redundancies
• Discounted cash flow approach- where the entity is in the start up stage
• Market based approach- where there is publicly available comparative information available
Case: TankCo, Roxanne Kalpert, Ferguson Real Estate, Solar Panel Solutions, Lake Country Camping
Derivative Instruments
Finance
Core – Level C; Elective – Level B
Derivative Instruments
Two common risks are foreign currency risk and interest rate risk. Derivatives can be used to hedge and mitigate those risks.
• Foreign currency risk: Hedge with a forward contract, future contract or options
o Forward: A contract to buy or sell a fixed amount of foreign currency dollars at a set future date. If hedging a future sale in foreign currency, then the entity would use the proceeds from the sale to settle the forward contract, fixing the amount of CDN dollars to be received from the sale.
o Future: A contract to buy or sell a fixed amount of foreign currency dollars at a set future date. Similar to forward contracts, but they are sold in fixed amounts with fixed maturity dates, so cannot match the timing and amount of the entity’s transactions exactly.
o Options: Purchase options to buy or sell foreign currency dollars at a certain price at a set future date. The entity has the right, not the obligation, to settle when the option matures.
• Interest rate risk: Hedge with an interest rate swap contract
o Usually entered into with a bank, and has the effect of converting a variable rate loan into a fixed rate loan.
Case: Atlantic Shellfish
Weighted Average Cost of Capital (WACC) Calculation
Finance
Elective – Level A
Weighted Average Cost of Capital (WACC) Calculation
Formula: WACC = MVe ÷ (MVe + MVd) × Re + MVd ÷ (MVe + MVd) × (Rd × (1 − t))
Where:
MVe – Market value of equity
MVd – Market value of debt
Re – Cost of Equity (see calculation below)
Rd – Cost of Debt
t – tax rate
Formula: Cost of Equity (Re) = Rf + β(Rm – Rf)
Rf - risk-free rate
Rm = rate of return expected from the market as a whole
β = beta for the underlying operations
Case: Ferguson Real Estate, Solar Panel Solutions
Capital Budgeting
Capital budgeting is a planning process used by organizations to determine which long-term investments to make.
a) The CPA Way
The first step is to assess the situation, which includes gathering both quantitative and qualitative information regarding potential project investments
• Sensitivity analysis is usually performed to test the impact of variations in underlying assumptions such as future cash flow projections and the discount rate.
• Relevant qualitative factors must also be for and against each project.
• To assist with the final selection, decision criteria must be developed and applied to determine which project(s) to accept.
1. Relevant cash flows
Capital budgeting projects are expected to generate cash flows over several time periods. Only the relevant incremental cash flows are included in any capital budgeting analysis — that is, the change in cash inflows and outflows directly attributable to investing in the project.
Time frame of the project and building the spreadsheet
This might be based on the useful life of the asset, the term of a contract, or even indefinitely in the case of investing in a new line of business or an intangible asset that has an indefinite life.
The information is usually gathered in a spreadsheet, with each column representing a specific time period , including Time 0 when the initial investment will take place. Positive cash flows are entered as positive numbers and negative cash flows as negative numbers.
Categories of cash flows
In assessing the incremental cash flows, there are four general categories considered for each capital project:
Initial investment costs:
The initial investment in a project will include all incremental capital expenditures. These cash outflows usually occur at Time 0 (the present time), but in some cases may extend over more than one period. For example, construction of a building might take two to three years to complete.
Opportunity costs:
If a new capital project involves the use of existing assets, the opportunity cost of converting assets to a different use must be considered. If an asset is unused, it can likely be sold — in which case the value of the proceeds of sale (after tax) are given up. If the asset is currently used, then its opportunity cost is the current value-in-use (after tax) to the company. Note that neither the original cost nor the book value of assets is relevant for this analysis.
This amount will be included as a cash outflow at Time 0 for this project when the land is used.
Tax benefits from capital assets:
The tax benefits arising from the investment made in a capital asset must also be considered. Under Canadian income tax rules, assets qualify for a specific CCA class that stipulates the amount of capital cost allowance (CCA) that may be deducted each year for calculating taxable income.
1. CCA deduction taken as part of the operating cash flows: In this method, the CCA claim related to the new capital assets is deducted each time period from the operating cash flows. Income tax is calculated on this net amount, and then the CCA is added back to arrive at net operating after-tax cash flows. The tax benefit of the CCA is captured with a lower income tax expense.
2. Present value of the tax shield on CCA: This method uses a formula, known as the present value of the tax shield on CCA formula (tax shield formula). This formula calculates the present value of all the future tax savings arising from the maximum annual CCA deduction claims allowed for the asset. This formula can only be used for assets that qualify for CCA classes where the CCA is calculated on a declining balance. The formula is as follows:
PV of the tax shield on CCA= (investment x CCA rate x tax rate/CCA rate + discount rate) X (1+0.5 x discount rate/1+discount rate)
Note that the second component of the formula {[1 + (0.5 × discount rate)] ÷ (1 + discount rate)}is used to adjust for the half-year rule in the year of acquisition .
After-tax operating cash flows
After-tax operating cash flows represent changes to revenues and operating costs specifically related to the project. The incremental cash flows might include increased sales, reduced variable or fixed costs, new variable or fixed costs, or any combination thereof. Net operating cash flows are all calculated on an after-tax basis.
In addition to the direct increases in revenues and costs related to the project, there are other items to consider:
• Sunk costs are costs that have already been incurred and are to be ignored in the project’s analysis.
• Side effects are positive and negative impacts on other parts of the business arising from investment in the project.
Investment in working capital
Any changes in required working capital resulting from the project must be included in the analysis. Working capital increases often result from higher receivables and inventories.
The company would show a net investment at Time 0 equal to the increase in inventories plus the increase in accounts receivable minus the increase in supplier payables.
Salvage values
Once the project is finished, the value of any existing assets must be recovered. This amount is the salvage value of the assets (proceeds to be received on disposal). There are three income tax impacts to include on disposition of assets:
• loss of any future CCA tax shield (see example below)
• tax payable on any recaptured CCA
• tax payable on capital gains that may arise if the selling price is greater than the original cost
Inflation
Inflation should be included in the calculation of relevant cash flows such as revenues, costs, and salvage values. An assumption for a future inflation rate must be determined and applied to all relevant cash flows.
2. Relevant discount rate
The company’s cost of capital (weighted average cost of capital) is the appropriate discount rate for projects financed in the usual capital structure proportions for the company when the risk level of the project is the same as the company’s typical risk. Otherwise, adjustments must be made. If the project is riskier (or less risky) than the company’s current operating business, then a higher (or lower) discount rate will be appropriate.
Before-tax versus after-tax discount rates
It is also important to remember that if the cash flows are given after tax, the internally consistent discount rate to use is also after tax. Conversely, if cash flows given are before tax, then the appropriate discount rate to use is also before tax.
For capital budgeting purposes, because the implications of income taxes can vary substantially depending on the entity and the nature of the assets used, all cash flows are determined on an after-tax basis. Accordingly, the discount rate used is also after tax.
Sources of funding for the project
Financing costs for cash flows related to debt (principal or interest) or equity (such as issuances or dividends) are therefore not usually relevant cash flows for the capital budgeting analysis. Finance costs are incorporated in the appropriate discount rate.
b) Analyze each project: Quantitative methods and tools
Once relevant cash flows are identified, several quantitative methods and tools can be used for analysis. Common methods for capital budgeting include:
• Net present value
• Internal rate of return
• Payback period (undiscounted or discounted)
Merits of the NPV method include the following:
• It considers the time value of money.
• Calculations are based on absolute dollar values and not percentages; therefore, the decision maker can sum the NPV of various investment opportunities to determine the total impact of any combination of projects.
• It’s possible to use varying discount rates, which is useful in addressing risk; the longer the project, the greater the risk that cash flows will not materialize.
Limitations of the NPV method include the following:
• Long-term cash flow forecasting may be difficult.
• It assumes that cash flows occur at the end of the period.
Internal rate of return
Internal rate of return
Another common quantitative method for capital budgeting is internal rate of return (IRR), which calculates the discount rate for the project that would cause the project’s NPV to be $0.
In the IRR method, the relevant cash flows are allocated to each period of the project’s life. A formula is then used to calculate the rate of return that results in a $0 NPV for the project.
Rule for acceptance (based only on quantitative analysis)
If the IRR is greater than the discount rate appropriate for the project, then the project should be accepted. If the IRR is less than the appropriate discount rate, then the project should be rejected.
Merits of the IRR method include the following:
• It considers the time value of money.
• It is easily understood.
Limitations of the IRR method include the following:
• The IRR method can have more than one result. If the periodic cash flows are positive and negative throughout the life of the project, there can be multiple IRRs. For example, this could happen if a major renovation requiring large cash outflows occurs later in a project’s life; the project would have two IRRs, making it difficult to conclude what the true return actually is.
• It cannot be used to rank projects because IRR assumes that project cash flows are reinvested at the project’s IRR. This problem arises when comparing two projects that differ in scale or timing.
• The IRR does not indicate the impact of the project on firm value in absolute dollars.
• The IRRs are not additive like NPVs and therefore cannot be combined.
Use IRR (value 1, value2,…) formula in excel (including range of Net incremental cash flows calculated in NPV analysis before discount factor application)
