L5: Capital Budgeting

Question 1

Why do opportunity costs matter and how do they contribute

Answer 1

If an existing asset (land, building…) is used in a new project, potential revenues from alternative uses of the assets are lost. This forgone revenues should be considered as a COST of the new project.

EX: like the market value of a building/land, you could be selling it but you’re using it for your project, so it’s your forgone revenues.

Question 2

Erosion, Canibalism and Synergies. What are they and how can they affect incremental Cash Flows?

Answer 2

• Cannibalism is when a new product decreases the demand, therefore sales, of an existing product of the company.
• Erosion is the decline in a company’s overall profitability or revenue due to the launch of a new project or product. This can be due to cannibalization, but also external factors like increased competition, market saturation, or shifts in consumer preferences.
• Synergies create increased demand for existing products. It’s when a new product increases the demand for the other as well.

Question 3

How does Investment in WC impac our Cash Flows?

Answer 3

• The OCF has to be adjusted for changes in Net WC
• To calculate these changes we do present level of WC - previous level of WC
• If it says that the NWC is recoverable after the project it means that the change in WC in T+1 corresponds to the recovery of all you NWC that you had in T. If this happens, you also need to account for this when computing the DCF!!

Question 4

What does CAPEX include?

Answer 4

• Includes the opportunity cost of unused land, building….
• All replacemnets during the project
• The capital can or not totally depreciate during the project.

Question 5

Terminal value Vs. Salvage value

Answer 5

• The salvage value is the net value you are expecting to get from the sale of the asset. So its the value of the sale minus the tax on capital gain from that sale.
• To actually calculate how much tax will be deducted, you do: (sale - book value)tax on capital gain
  SV=Sale P-(Sale P-BV)*t
• The terminal value is the value of your capital at the end of the project.
  TV=SV-(SV-BV)*t

Question 6

Terminal value if the project continues indefinitely

Answer 6

• If there’s no end for the project, instead of a terminal value we calculate a continuation value

CV=FCF(1+g)/(r-g)

Question 7

How to do ICF?

Answer 7

ICF=-CAPEX-change NWC+TV

The logic behind this is thinking about all the investment it was made in the project:
- The CAPEX is positive, but in therms of cash flow investment, money is leaving, thus it appears with a (-) sign.
- The change in NWC, if positive it means we are investing more WC into the project so it is with a (-) sign as well.
- The TV is additional value from your project (your machine didn’t depreciate completely) so it’s with a (+) sign