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Finance > Further on Capital Budgeting > Flashcards

Further on Capital Budgeting Flashcards

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1
Q

What are annuities?

A

An annuity means receiving the same cash flow each and every period, starting with one period, for a finite number of periods

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2
Q

How is the present value of an annuity found?

A

1/r(1-1/1+r^n)

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3
Q

How does the amount of cash differ each year for an annuity?

A

Exactly the same amount of cash is received year on year for a finite number of period.

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4
Q

What does the annuity formula show?

A

It gets the PV factor for an annuity in one step, without considering its individual cash flows

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5
Q

What is a perpetuity?

A

A perpetuity means receiving the same cash flow each and every period forever, starting with period one.

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6
Q

What is the formula for a perpetuity?

A

1/r

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7
Q

What is the difference between nominal and real cash flow projections?

A

Real cash flow projections project future volumes at current prices and do not include inflation whereas nominal cash flows include inflation, the project future volumes at expected future prices.

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8
Q

How does the discount factor vary between nominal and real cashflows?

A

Use nominal discount rate to discount nominal cash flows. Use real discount rate to discount real cash flows. They should both give the same answer.

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9
Q

Which formula links the nominal, real and inflation rates?

A

(1+rnominal) = (1 +rreal)(1+E[inflaton rate])

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10
Q

What Is the conversion for the linkage of nominal, real and inflation rates?

A

rnominal = (1+rreal)(1+E[inflation rate]) - 1

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11
Q

How do you find a half yearly rate, quarterly rate and monthly rate if r is annual?

A

Half yearly rate = r/2
Quartlerly rate = r/4
Monthly rate = r/12

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12
Q

When will sums grow or diminish faster?

A
  • Sums will grow faster if compounded more frequently than annually
  • Sums will diminish faster if discounted more frequently than annually
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13
Q

What is annual percentage rate (APR)?

A

The rate per period multiplied by the number of period in a year.

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14
Q

What is the effective annual percentage rate (EAPR)?

A

Considers the impact of compounding or discounting more frequently than annually.

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15
Q

What are truly equivalent rates?

A

The periodic interest rate equivalent to y% per annum, if there are n periods in a year:

n`/(1 +y) - 1

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16
Q

What factors add complexity to international capital budgeting decisions?

A
  • Exchange controls
  • Intracompany transfer of assets and profits
  • Exchange rate fluctuation where cash flows are in foreign currency
  • Differential tax rates
  • Political risk
  • Cannibalisation
17
Q

What are exchange controls?

A

Restrictions placed by host countries on foreign owned local companies to remit profit/fund their parents

18
Q

How to exchange controls impact international capital budgeting?

A

International project should only be evaluated based on the parent’s cash flows i.e cash flows that are ultimately remitted to the parent

19
Q

In the absence of exchange controls, how do the parents cash flows relate to the project’s cash flows?

A

Parents cash flows = project cash flow

20
Q

In the presence of exchange controls, how to the parent’s cash flows relate to the project’s cash flows?

A

They do not equal each other

21
Q

How do parents get cash flows?

A

They can extract profits from foreign subsidiaries/operations through management fees, royalties, dividends, asset transfer, interest etc

22
Q

What do parent’s cash flows consist of?

A
  • Equity put into overseas projects
  • Dividends remittable back from overseas project
  • Loans put into overseas project
  • Equity capital remitted back to parent
  • Loans interest
  • Loans repayment
  • Management fees from overseas project
  • Equipment or inventory contributed to overseas project
  • Tax effects on remittance
  • Terminal values
23
Q

How do exchange rates provide complications?

A

Exchange rate between the parent country and the project country will fluctuate throughout the project’s life.

Need to incorporate these into NPV calculation

24
Q

What is the first method of exchange rate treatment?

A
  1. Estimate future cash flows in local currency and money terms
  2. Convert to home current using forecast ERs
  3. Calculate present value using home currency money terms and discount rates
25
Q

What is the second method of exchange rate treatment?

A
  1. Estimate future cash flows in local currency and money terms
  2. Calculate PV using local currency money terms discount rate
  3. Concert to home currency PV using spot rate
26
Q

What is the third method of exchange rate treatment?

A
  1. Estimate future cash flows in local currency and money terms
  2. Reduce to real terms flows In local currency by discounting for local inflation
  3. Convert to home currency using post exchange rate
  4. Convert PV using real terms discount rate
27
Q

What is the fourth method of exchange rate treatment?

A
  1. Estimate future cash flows in local currency and money terms
  2. Reduce to real terms flows In local currency by discounting for local inflation
  3. Calculate PV using local currency money terms discount rate
  4. Convert PV using real terms discount rate
28
Q

How does taxation provide a complication?

A
  • Taxation arising from the project profit may be subjected to different tax treatment
  • Additional tax may still be payable to home government even though the foreign project’s profit has been taxed once by foreign gov
  • All relevant taxation charges should be incorporated in NPV
29
Q

What complication does political risks provide?

A
  • Investments in foreign countries attract political risks
  • May ultimate payoffs from investments
  • Can increase discount rate applied or incorporate risks in the CF forecasts
30
Q

How is cannibalisation a complication?

A
  • It means a new project is taking away revenue from an existing project
  • Must be considered in appraisals
  • Applies to domestic and international investments
31
Q

What is the international capital budgeting model?

A

NPV = Sum of free cash flows/(1 +r)^n - investment costs

32
Q

How are free cash flows calculated in the international capital budgeting model?

A

Free cash flows = revenue - COS - operating expenses - tax + depreciation - change in investment in working capital/capital expenditure

33
Q

What does r mean in the international capital budgeting model?

A

r = cost of capital

Finance (6 decks)

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