Finance - Capital Budgeting - Overview and Relevant Cash Flow

Question 1

What are some forms of capital budgeting that can help strategic objectives?

Answer 1

1. Expand or improve operating activities
2. Replace or relocate operating capacity
3. Form or acquire new subsidiary companies

Question 2

Provide three administrative areas of the capital budgeting process

Answer 2

1. Project generation - Innovation and sensitivity to consumer needs future profitability, and market niche
2. Project approval - Significant expenditures require formal capital budgeting
   Ex. Top management approves large projects, and middle/ smaller managers approve smaller projects
3. Project follow-up - Regular reporting of cash flow, the executive can see whether original cash flow are accurate follow-up procedures, reduce conflict of interest

Question 3

What types of quantitative analysis are used for capital budgeting

Answer 3

Need: - Relevant cash flow & Relevant discount rate
Quant:
1. NPV
2. Initial rate of return (IRR)
3. Payback period, undiscounted or discounted
Test assumption - Use sensitivity analysis

Qualitative Analysis - Relevant Qualitative Factors

Question 4

How do you determine what is used for relevant cash flow? Provide the categories of cash flow

Answer 4

• Have to identify the inflow and outflow over the time frame that is expected for the potential project investment
  Ex. if the project is undertaken, it will increase outflow from $500,000 to $560,000. An incremental cash flow of $60,000 is included

Categories of cash flow
1. Initial investment: Capital expenditure, opportunity cost, tax benefit arising
2. After-tax operating cash flow: Incremental revenue, incremental fixed cost, incremental variable cost, incremental revenue, and cost
3. Working capital: Increases in working capital, reduction of working capital at the end of the project
4. Salvages values: Sales of disposal of an asset, Tax effect including any loss on CCA

Question 5

Explain what opportunity cost is and tax benefit from capital asset investment

Answer 5

1. Opportunity cost - is the forgone benefit from choosing one alternative over the next best alternative
   Ex. New plant on existing land - Original cost $150,000 appraisal is $890000. Can either use the land to build new plant to sell property
   Proceed of sale of land (890000(1-0.04)) 854400
   Income tax payable (854400-15000050%*15%=-52830
   Opportunity cost : 854400 - 52830 = 801570
2. Tax benefit
   - Is determined from capital investment by other CCA roles the capital asset deducted each year
   - UCC pool increase at a given year of the amount of net acquisition.
   - Disposal - If the company suffers a loss, can elect not to take CCA in that year to save deduction in a future year

Question 6

What are the two types of methods to calculate tax savings and provide the formula for PV of tax shield of CCA

Answer 6

Two methods to calculate:
1. CCA deduction is taken as part of the operating cash flow: CCA claim related to new capital assets is deducted each period from the operating cash flow
2. PV of the tax shield of CCA - Simplify the calculation of the PV of the total infinite tax shield from CCA.

PV of tax shield CCA - Half year : (Investment * CCA rate * Tax rate) / Discount rate + CCA rate * 1+.05*Discount rate )/ 1 + Discount rate

PV of tax shield on CCA - AII : (Investment * CCA rate * Tax rate) / Discount rate + CCA rate
* (1+1.5*Discount rate) / 1 + Discount rate

Temporary 100% deduction: (Investment * corporate tax rate ) / 1 + discount rate

• Inflation should be used in calculation of relevant cash flow & salvage value

Question 7

What are some factors to consider for the after-tax operating cash flow

Answer 7

• Some increases and decreases of cost-related projects are:
  1. Sunk cost - a cost that has been incurred but should be ignored in project analysis. Ex. R&D
  2, Side effect - can have a positive or negative impact, and represent incidental increases in cash flow. Decrease due to loss of sales of competing products

Question 8

Explain how investment in working capital

Answer 8

• Working capital investment relates to A/R, A/P, Inventories resulting in project
• Need to remember that is sales increase on a project, inventory, and A/R will increase as well
  -A/R does not occur until inventory is sold to the customer on account
• Working capital is recovered when inventories are liquidated, A/R is collected, supplier is paid

Question 9

Explain how is salvage value determined for capital budgeting and inflation

Answer 9

Salvage value - where existing assets must be recovered, proceeds to be recovered from disposal
- Loss on any future CCA tax shield, tax payable recapture CCA

PV of lost in tax shield on CCA salvage = (Salvage proceeds * CCA rate * corporate tax rate) / CCA rate * Discount rate

Tax on recapture at time of salvage - salvage proceeds * tax rate

Inflation - This should be included in the calculation of relevant cash flows such as revenue, cost, and salvage value.
Relevant discount rate -
Nominal vs real discount rate
(1+nnominal rate of return) = (1+Real rate of return)*(1+inflation)