Lecture 3: Fundamentals of Capital Budgeting (Chapter 9)

Question 1

What is the first step in analyzing various investment opportunities?

Answer 1

It is by compiling a list of potential projects.

Question 2

What is Capital Budget?

Answer 2

It lists the projects & investments that a co. plans to undertake during the next period.

Question 3

What is Capital Budgeting?

Answer 3

It refers to the process carried out by a firm in order to analyze projects & investments opportunities to decide which ones to accept. This process begins w/ forecast of each project’s future consequences for the firm.

Question 4

What is Incremental Earnings?

Answer 4

It is the amount by which a firm’s earnings are expected to change due to investment decisions. (If a project leads to increase in sales or reduction in expenses, then we should undertake that project)
It tells us how the decision will affect the firm’s reported profits from an accounting perspectives.

Question 5

What is the ultimate goal?

Answer 5

To determine the effects of the decision to accept / reject a project on the firm’s cash flows & evaluate the NPV to assess the consequences of decision for the firm’s value. The reason why we need to estimate a project’s cash flows is to determine its NPV & decide if its a good project for the firm to invest in.

Question 6

What is an important source of information?

Answer 6

It is looking at past projects of the firm, or those of other firms in the same industry.

Question 7

What is operating expenses?

Answer 7

It is the upfront investment in the year that they are incurred.

Question 8

What is capital expenditures?

Answer 8

It refers to a co.’s investment in terms of assets / PPE (cash expenses are not directly listed as an expense when calculating earnings.

Question 9

Are investment in PPE considered operating expenses?

Answer 9

No, instead they’re considered as cash expenses and are not directly listed as expenses when calculating earnings. Instead, the firm deducts a portion of its cost each year as depreciation.

Question 10

Does depreciation expenses correspond to the actual cash outflows?

Answer 10

No. It is considered a non-cash item, therefore we must always add back to the incremental earnings after deducting to obtain taxable income. This is to arrive at the actual cash flow of the co.

Question 11

What is straight-line depreciation?

Answer 11

Its asset cost is divided equally over its depreciable life.

Question 12

Why is incremental revenue and cost estimates important?

Answer 12

They develop an estimate of sales & refine its estimates of costs for the co.

Question 13

Factors to consider when estimating a project’s revenues & costs:

Answer 13

1. A new product typically has lower sales initially (customers then gradually become aware of the new products, sales will then accelerate & ultimately decline when product is near obsolescence / faces increased competition).
2. The average selling price of a product & its cost of production will generally change over time (prices & costs increases relative to inflation; prices of technology products fall over time as newer, more superior technologies emerge & production cost decreases).
3. For most industries, competition tends to reduce profit margins over time.

Question 14

What is our main focus of incremental revenue and cost estimates?

Answer 14

The evaluation is on how the project will change the cash flows of the firm. Thus, the focus is on incremental revenues and costs; we’re only concerned about the additional sales and costs generated by the projects.

Question 15

Incremental Earnings Before Interest and Taxes (EBIT) =

Answer 15

Incremental Revenue - Incremental Costs - Depreciation

Question 16

What is Marginal Corporate Tax Rate?

Answer 16

The tax rate a firm will pay on an incremental dollar of pre-tax income. (Income tax = EBIT x marginal corp. tax rate)

Question 17

What is Marginal Corporate Tax Rate?

Answer 17

The tax rate a firm will pay on an incremental dollar of pre-tax income. (Income tax = EBIT x marginal corp. tax rate)

Question 18

Incremental Earnings after tax =

Answer 18

(Incremental revenues - Incremental costs - Depreciation) x (1 - tax rate)

Question 19

Must the depreciable life of an asset always be similar to the economic life of the asset?

Answer 19

No, it isn’t always that way. It depends on whether the question did provide information about the depreciable life of the asset. If it isn’t provided, then only we will use the economic life of the asset.

Question 20

What is the function of pro forma statement?

Answer 20

It’s figures are not based on actual data (depicts the firm’s financials under a given set of hypothetical assumptions)

Question 21

What is the relation between taxes and negative EBIT?

Answer 21

Whenever a depreciation expense causes a negative EBIT, the taxes incurred on this EBIT will help reduce the incremental earnings.

Question 22

What is unlevered net income?

Answer 22

It indicates that it does not include any interest expense associated w/ debt.

Question 23

In capital budgeting, we calculate net income w/ the assumption no debt was used. So, what is this net income regarded as?

Answer 23

It is regarded as unlevered net income of the project, which indicates that it does not include any interest expense associated w/ debt.

Question 24

Is it true that additional losses incurred will offset and reduce the taxable income?

Answer 24

Yes, becxause we’ll take the pretax income less the operating losses incurred and from there only find the taxable income. When there isn’t any operating losses, then we’ll have to use the pretax income to straight calculate its taxable income based on the marginal tax rate.

Question 25

Do earnings represent the real profits?

Answer 25

Nope, earnings are an accounting measure of the firm’s performance. Firm cannot use its earnings to buy goods, pay employees, fund new investments or pay dividends to their shareholders.

Question 26

What is Incremental Free Cash Flow?

Answer 26

It is the incremental effect of a project on a firm’s available cash.

Question 27

What can we say about capital expenditures and depreciation?

Answer 27

• depreciation is a non-cash expense that is paid by the firm
• depreciation is not a cash flows, thus we do not include it in the cash flow forecast
• depreciation reduces our taxable earnings & thus reducing taxes
• we need to (+) back depreciation to the incremental earnings after computing the taxable income to recognise the fact that we still have cash flow associated to it

Question 28

How do we calculate incremental free cash flow?

Answer 28

Firstly, we’ll deduct depreciation to find the taxable income. From there, we’ll get our incremental earnings. To obtain incremental free cash flow, we’ll then need to add back depreciation because it is a non-cash item.

EBIT - income tax at marginal tax rate = Incremental earnings + depreciation - purchase of PPE = Incremental free cash flow

NOTE: We need to add back depreciation in computing the incremental cash flow because it is a NON-CASH ITEM!!!

Question 29

What is Net Working Capital?

Answer 29

The difference between receivables & payables is the net amount of the firm’s capital that is consumed as a result of these credit transactions. (When NWC increases, this reflects additional investment in working capital. It represents a cash flow in that year).
Net Working Capital = Current assets - Current liabilities
*current assets: cash + inventory + receivables
*current liabilities: payables

Note:

1) Receivables measure the total credit that the firm has extened to its customers
2) Payables measures the credit the firm has received from its suppliers.

Question 30

Why is Net Working Capital important?

Answer 30

It reflects a short-term investment that ties up cash flows that could be use elsewhere. This is because money has time value and we cannot ignore this delay in our forecasts for projects.

Question 31

Why do firms need to maintain a minimum cash balance?

Answer 31

It is to meet unexpected expenditures and inventories of raw materials and finished products to accommodate production uncertainties and demand fluctuations.

Question 32

What happens when net working capital increases?

Answer 32

It reflects that there is additional investment in working capital, thus it represents a reduction in cash flow for that particular year.

NOTE: Only net working capital impacts the cash flows.

Question 33

What is the relationship between net working capital and cash flows?

Answer 33

They are both indirectly proportional to one another. When net working capital increases, the cash flows reduces.

Question 34

In the last year of the project, will free cash flow be recovered?

Answer 34

Yes it will. Therefore, this offsets the net working capital invested at the beginning of the project.

Question 35

Free Cash Flows =

Answer 35

(Revenues - Costs) x (1 - Tax Rate) - Capital expenditure - change in working capital + (tax rate x depreciation)

OR

Revenue - cost - depreciation x (1-T) - capital expenditure - change in net working capital + (tax rate x depreciation)

Question 36

What is Depreciation Tax Shield?

Answer 36

It is tax savings that results from the ability to deduct depreciation (depreciation expense have a +ve impact on FCF)
Tax rate x depreciation = Depreciation Tax Shield

Question 37

How do we compute NPV?

Answer 37

Discount the free cash flow at the appropriate cost of capital.

Question 38

What is cost of capital?

Answer 38

It is the expected return that investors could earn on their best alternative investment w/ similar risks & maturity.

Question 39

What is the formula for calculating NPV?

Answer 39

NPV = investment in year 0 (-ve) + present value of free cash flows in every year (FCF / cost of capital)

Question 40

When computing incremental free cash flows of an investment decision, what should we include?

Answer 40

We should include all changes between the firm’s free cash flow w/ the project vs. w/o the project.

Question 41

What is opportunity costs?

Answer 41

It is the value a project could have provided in its best alternative use (resources could provide value for the firm in another opportunity / project). Such value is lost when the resource is used by another project. This should be included as an incremental costs of a project.

Question 42

What is project externalities?

Answer 42

It refers to the indirect effects of a project that may increase / decrease the profits of other business activities of the firm.
Eg: cannibalization which refers to the sales of a new product displaces sales of an existing product.

Question 43

What is sunk costs?

Answer 43

It is an uncoverable cost for which the firm is already liable (have been paid / will be paid regardless of the decision whether or not to proceed w/ the project).

Question 44

What are the examples of sunk costs?

Answer 44

1. fixed overhead expenses - affect many diff areas of an org., often allocated to diff business activities for accounting purposes, NOT incremental to the project & should NOT be included in computing incremental earnings. (eg: CEO fixed salary). We only include additional overhead expenses as incremental expenses if it arise because of the decision to take on the project.
2. Past R&D costs - co. cannot get its development costs back regardless whether the R&D brings benefit or not, therefore it shouldn’t be considered when calculating incremental earnings.
3. Unavoidable competitive effects - eg: cannibalization. Lost of sales are a sunk cost & should NOT be included in the projections

Question 45

How does time affects the incremental free cash flows?

Answer 45

Firms often choose shorter intervals for riskier projects so that they might forecast cash flows at monthly level for projects that carry considerable risks.

Question 46

What is accelerated depreciation?

Answer 46

It accelerates its tax savings & increase their present value.

Question 47

What is Modified Accelerated Cost Recovery System (MACRS)?

Answer 47

• categorizes assets according to their recovery period

- allows for partial depreciation in the year when assets is purchased & put into service

Question 48

What is the advantage of MACRS?

Answer 48

It allows for larger depreciation deductions earlier in the asset’s life, which increases the present value of the depreciation tax shield and so will raise the project’s NPV. A larger percentage of depreciation comes earlier as compared to straight-line basis depreciation.

Question 49

What is liquidation or salvage value?

Answer 49

Assets that are no longer needed often have a resale value, or salvage value if the parts are sold for scraps. *In calculating the FCF, we should include the liquidation value of any assets that are no longer needed & may be disposed off.

Question 50

When assets are liquidated, will capital gain be taxed?

Answer 50

Yes, it’ll be taxed as income.
Capital Gain = sales price - book value
Book value = purchase price - accum. depreciation
After-tax cash flow from sale of asset = sale price - (tax rate x capital gain)

Question 51

How to compute book value?

Answer 51

It is the ori purchase price of the equipment less accumulated depreciation.

Question 52

How does a firm identifies its marginal tax rate?

Answer 52

By determining the tax bracket that it falls into based on its overall level of pretax income.

Question 53

How does tax loss carryforwards or tax loss carrybacks work?

Answer 53

It allows corporations to take losses during a current year and offset them against gains in nearby years. When firms can carry back losses, it receives a refund for back taxes in the current year.
A firm can also carry forward losses & use it to offset future taxable income.
A firm can offset losses during one year against income for the last 2 years OR save the losses to be offset against income during the next 20 years.

Question 54

What happens when a firm can carryback losses?

Answer 54

It receives a refund for back taxes in the current year. Otherwise, it must carry forward the loss and use it to offeset future taxable income.

Question 55

What happens if a firm has tax loss carryforwards well in excess of its current pretax income?

Answer 55

Additional income it earns today will simply increase the taxes it owes after it exhausts its carryforwards.

Question 56

What is replacement decisions?

Answer 56

Financial managers often must decide whether to replace an existing piece of equipment. (New equipment may allow increased production, resulting in incremental revenue, or it may simply be more efficient, lowering costs)

Question 57

What should financial managers do when evaluating a capital budgeting project?

Answer 57

They should make decisions that maximizes the NPV.

Question 58

What is sensitivity analysis?

Answer 58

It is a tool for assessing the effect of uncertainty in forecasts.
A capital budgeting tool that determines how the NPV varies as a single underlying assumption is changed.
- allows us to explore the effects of errors in NPV estimates
- assess the sensitivity of NPV to uncertainty about the correct cost of capital to use as a discount rate
- reveals which aspects of a project are most critical when we’re actually managing the project.

Question 59

What is Break-Even Analysis?

Answer 59

It is the level of a parameter for which an investment has a NPV of zero.
(most useful perspective for decision-making)

Question 60

What is Accounting Break Even EBIT break-even?

Answer 60

It is the level of a particular parameter for which a project’s EBIT is zero.
= units sold x (sale price - cost/unit) - SG&A - Depreciation = 0

Question 61

What is scenario analysis?

Answer 61

A capital budgeting tool that determines how the NPV varies as a number of underlying assumptions are changed simultaneously.
We can also use this tool to evaluate alternative pricing strategies.

Question 62

What is real options?

Answer 62

The right, but not the obligation, to take a particular business decision (only do so if it increases the NPV of project)
Note: Real options add value to an investment opportunity because it allows decision-maker to choose the most attractive alternative after new information have been learned.

Question 63

What are the 3 options available?

Answer 63

1. Option to delay: waiting could be valuable if we are expecting the price of the components to decrease substantially, making the components obsolete.
2. Option to expand: the option to start w/ limited production, expand only if the product is successful (this will increase the NPV of product) (eg: test market the product in limited release before committing to it fully)
3. Option to abandon: option to walk away (can add value to a project because a firm can drop a project if it turns out to be unsuccessful)

All these options provide flexibility to the project, thus increasing our NPV.