L1: Capital Budgeting Flashcards
Principles of capital budgeting
Simple NPV formula
Where do we get the r_f from?
What is r/cost of capital?
- How is it affected if we can lend money at a lower rate?
- Do we use the market or book value in the NPV?
- What if we made a dividend promise to S/H?
What CF should be respected in discounting?
Should we use true CF or accounting earnings?
Is Depreciation included in EBIT? Where do we need to be careful in the FCF?
What is when included in CAPEX?
How is NWC included in the FCF?
What should be included in initial expenditure?
Net Working Capital (NWC) formula
Continuation/salvage value
Project ends at the terminal date
Continuation value if project continues after cash flow projection period ends
What effect has depreciation on the CF?
Investments: CAPEX and NWC
Maintenance / CapEx
All capital expenditure during the life of a project has to be deducted from the cash flow
Net working capital
Continuation/Salvage value
If the project ends at the terminal date
Continuation value if project continues after CF projection period ends
Would interest costs appear in NPV calculations?
No! This is a financing cost we ignore in capital budgeting decisions
Straight line depreciation
(Initial cost-salvage value)/life-time years
NWC of a project
Taxes on capital gain
Why is working capital a negative CF?
An increase in NWC reduces the companies CF
Why is depreciation not counted in net CFs? Is the cost of consuming your capital equipment not a real cost?
Not a cash outflow→only effect on CF is through taxes→higher depreciation reduces firms taxes
Would interest appear in the FCF calculation?
NO→financing cost we ignore in capital budgeting decisions
What do we assume about inflation?
Nothing particular
If nominal CF → use nominal rate
If real CF → use real rate
What about feasibility study?
This is a sunk cost we ignore
What does asset pricing theories tell us?
What is the compensation for risk?
What do we use in real life as the market portfolio?
S&P500 or FTSE100 (UK)
Should a family firm use the CAPM when evaluating projects?
May not be appropriate to use CAPM to to estimate the discount rate for the firm’s projects bc family companies are often not well diversified (-> often reinvest most of their cash)
CAPM relies on the assumption that the only risk that investors care about is the systematic risk bc they have fully diversified the firm specific risk
What r_f to use?
What r_m to use?
In principle, we should use the expected risk premium for the value-weighted universe of assets
Practice: use the historic arithmetic average of the difference between the return on the market index (value weighted NYSE/AMEX/NASDAQ, S&P 500)
In our course we will use the historical US risk premium of 6% as a base
r_m - r_f in practice
If we know the historic return of our stock, why not use that as our cost of capital? After all, that is what investors got for giving us their money
The historic returns of the stock reflect the riskiness of the firms equity but not the risikness of the project (may be different)
What should the cost of capital for a project reflect?
Cost of capital for a project should reflect how much investors could expect to get on a ”similarly risky” investment in financial markets → This is the other ”opportunity” for the investor
What cost of capital to use?
Historical risk and return
Why do asset prices fluctuate?
What all asset pricing theories tell us
CAPM
- What does it tell us
- Formula
What is the beta of an asset?
What beta to use? Stora Enso’s estimated equity beta is 0.96. Can we use this?
Estimating β from a company that is not a 100% equity financed
Identical Twin Method
How to unlever company β?
Why do companies who have debt have riskier equity?
What is the usual $\beta_D$ of a company?
Rules when unleveraging beta
