LT (1) Capital Budgeting

Question 1

What is corporate finance?

Answer 1

Corporate finance is the study of how corporations make financial decisions.

A corporation is a legal entity (i.e. a legal ‘person’) owned by, but legally distinct from its owners (‘shareholders’). It is typically characterised by:
Limited liability for its shareholders
Separation of ownership and control

Goal of the firm: maximise shareholder wealth.

Question 2

What is capital budgeting?

Answer 2

A key task of managers is to allocate capital between projects. Stand-alone: Is Project A better than doing nothing? Mutually exclusive: Is Project A better than Project B?
Our focus will be on the financial tools for valuation. These tools attach numerical values to projects to aid comparison and assist in the decision-making process.

Question 3

What is the opportunity cost of capital?

Answer 3

Financial managers should always consider the opportunity cost of investing in a project.

The alternative to investing is paying a dividend to shareholders and then the shareholders can invest for themselves

Question 4

What is the net present value formula?

How do you use it? (What rules do you need to keep in mind.)

Answer 4

NPV0 =CF0+E(CF1)/(1+r)+ E(CF2)/(1+r)^2 +……

r is the opportunity cost of capital

(riskier investments, higher r)

NPV converts a project’s future cash flows into comparable quantities that can simply be summed. The NPV is the $ contribution of the project to firm value in today’s money.

Accept project if NPV > 0.

To calculate NPV, we need to forecast a project’s expected after-tax free cash flows (FCF). FCFs are the cash flows ‘left over’ to distribute to investors after all operating expenses and capital expenditures have been made.

Rules:
Only cash flows are relevant!
Estimate cash flows on an incremental basis
Include opportunity costs Ignore sunk costs
Include all externalities
Treat inflation consistently

Question 5

What are the advantadges of using NPV? (3)

Answer 5

1 )Precise. NPV accounts for:
Time value of money
Compensation for bearing risk

2) Convenient: present values are additive NPV(A+B) = NPV(A)+NPV(B)
Assuming Projects A and B are independent

NPV based on cash flows not accounting earnings.

Question 6

What are the alternativative valuation methods that compete with NPV for capital budegting? (3)

Answer 6

1) Book rate of return
2) Payback period
3) Internal rate of return

Question 7

How do you use the book rate of return?

Answer 7

Book rate of return = Book Income/Book Assets

Average income divided by average book value over project life.

Decision rule: Accept if book rate of return is ‘high enough’.

Rarely used to make decisions.

Question 8

What are the issues with using the book rate of return as a valuation method?

Answer 8

1) The components reflect tax and accounting figures and are not market values or cash flows (open to manipulation)
2) Time value of money is ignored
3) Only considers averages, and risk is ignored

Question 9

How do you use the payback period valuation method?

Answer 9

Payback Period: the number of years it takes before the cumulative forecasted cash flows of a project equals the initial outlay.

Decision rule: Accept projects that “payback” within a desired time frame.

Question 10

What are the issues with using the payback period as a valuation method?

Answer 10

Ignores all cash-flows after the payback period

Ignores time value of money and risk, although this can be remedied by discounting cash flows before calculating the payback period (called ’discounted payback’)

Decision rule is arbitrary

Biased against long term projects

Question 11

What is the internal rate of return valuation method?

Answer 11

Accept investment opportunities offering internal rates of return that are higher than the opportunity cost of capital.

IRR > cost of capital

When the cost of capital = expected return on investment, NPV = 0
The IRR is the discount rate that makes NPV = 0

This opportunity cost of capital is also called the project’s
hurdle rate

NPV0 = 0 = CF0+ E(CF1)/(1+IRR) + E(CF2)/(1+IRR)^2 + E(CF3)/(1+IRR)^3 +…

Question 12

The quadratic formula may have to be used to find out the irr, (setting x= 1/1+IRR) what is the formula for the quadratic formula?

Answer 12

x=-b(+ or -) (b^2-4ac)^1/2 / 2a

Question 13

What are the Pitfalls of using the IRR? (4)

Answer 13

Blindly applying the IRR rule can lead to incorrect decisions (i.e. accepting negative NPV projects).
We need to be wary of:

1) Lending vs. borrowing

Two streams of cash-flows, both same in magnitude but opposite in sign, will have the same IRR.

For financing projects (Borrowing ie. positive cash flow at time = o), IRR rule needs to be reversed: only accept if IRR < cost of capital.

2) Multiple IRRs

Certain cash flows streams can generate NPV = 0 at two (or more) different discount rates.
This can happen when future cash flows change sign more than once. (AS MANY RATES OF RETURN AS THERE ARE IN CHANGES OF SIGN )

3) No IRR
It is possible to have no IRR and a positive NPV, or no IRR and a negative NPV.
These are projects that should always be accepted or rejected, respectively.

4) Mutually exclusive projects

Decision rule: pick the project with the highest IRR.
Don’t compare apples to oranges: the projects being compared should be in the same risk-class (i.e. same cost of capital)

IRR doesn’t take into account differing levels of risk

The IRR rule can sometimes result in incorrect decisions when projects differ in their scale and/or the timing of their cash flows.

(IRR is only a function of return, but investors prefer wealth over the return.)

Where cash flows arrive relatively earlier, project is favoured by IRR, but not necessarily better at the cost of capital.

Question 14

How can the issues that arise from using the IRR valuation method for mutually exclusive projects be remedied?

Answer 14

Calculating the IRR of the incremental cashflows that would result from taking one project instead of the other provides a potential remedy when comparing mutually exclusive projects.

KEY: MAKE THE INCREMENTAL CASH FLOWS LOOK LIKE AN INVESTMENT PROJECT (-ve cash flow initially) (Rather than financing project which would stuff up the IRR rule.)

Incremental Cash flow of investing in Project A instead of B is =A-B at each time period

If the IRR beta exceeds the cost of capital and so does the IRR of the incremental investment in A. Choose Alpha.

The incremental IRR corresponds to the cross over point between the two NPV profiles.

Question 15

What is the FCF formula?

Answer 15

Approach: start with incremental accounting earnings and then adjust to get to free cash flows.
FCF = EBIT(1−τc )+Depreciation−∆NWC−CAPEX+Salvage

Assume it is equity financed (ie. no debt.)

where:
EBIT = Earnings before interest and taxes
NWC = Net working capital = Curr. Assets − Curr. Liab. CAPEX = Capital Expenditures (i.e. investment)
Salvage = after-tax recovery value of used productive capital τc = marginal corporate tax rate

Note: we ignore any interest expenses in the FCF calculation. Rationale: Keep investment and financing decisions separate.

Alternatively:

Since EBIT = EBITDA − Depreciation:

EBITDA = Earning before: interest, taxes, depreciation & ammortirisation

FCF = EBITDA(1−τc )+Depreciation×τc −∆NWC−CAPEX+Salvage

The term Depreciation × τc in the equation above is the tax benefit provided by depreciation, and is called the depreciation tax shield

Because depreciation is a non-cash expense that reduces a firm’s tax bill (a cash expense).

Question 16

Why is CAPEX negative in the FCF equation?

Answer 16

Since investments in Plant, Property & Equipment (e.g. machinery) cannot be claimed as an expense for accounting purposes, they do not appear on the income statement directly.
But investments cost money!!
This expenditure will lower available FCFs, hence we subtract captial expenditures/investments in the FCF calculation

Question 17

How does one calculate Salavge value and why is it postive in the FCF equation?

Answer 17

Salvage Value:
Used equipment can sometimes be sold. If the sale price of the asset exceeds its book value, then we need to pay tax on the gain. The after-tax proceeds of this sale (the “salvage value”) is a cash inflow that will increase FCF.

Salvage value = Sale Price − (Gain on sale ×τc )
Gain on Sale = Sale Price − Book Value
Book Value = Initial Investment − Accumulated Depreciation

Question 18

Why is depreciation positive in the FCF equation?

Answer 18

Because depreciation is a non-cash expense that reduces a firm’s tax bill (a cash expense).

Reduces amount of tax paid (Which is a positive cash flow on our income)

Question 19

Why is the change in net working capital negative in the FCF equation and how do you find it?

Answer 19

Net working capital (NWC):
NWC = Current Assets − Current Liabilities

Main Current Assets (CA): Inventory, Accounts Receivable Main Current Liabilities (CL): Accounts Payable

NWC captures how much liquidity is tied up in the operation. Accounts receivables (payables) are earnings (expenses) for which you are yet to receive (pay) cash.

Purchases of inventory require cash but won’t be recognised as an expense until the goods are sold.

A growth in NWC means a net investment in current assets, tying up more cash and thereby decreasing free cash flow. Therefore, we subtract the change in NWC.
∆NWCt = NWCt − NWCt−1 = ∆CAt − ∆CLt

Question 20

Under straight line depreciation how does one calculate the annual depreciation expense?

Answer 20

Under straight-line depreciation, the annual depreciation expense is a constant proportion of the difference between the initial investment and the salvage value:

Depreciable amount = Initial Investment − Salvage value
Annual Depreciation = 1/T × Depreciable Amount

Question 21

What is the relationship between nominal interest rate (rnom), the real interest rate (ireal), and the (expected) inflation rate (π):

Answer 21

1+ireal = 1+rnom/ 1+π

Be consistent in how you handle inflation!
Use nominal interest rates to discount nominal cash flows Use real interest rates to discount real cash flows
You will get the same results, whether you use nominal or real figures.

Question 22

What are the two NPV applications?

Answer 22

1) Profitability index

When the total amount of funds available for investment are limited (called ‘capital rationing’), the Profitability Index (PI) provides a tool for selecting among various project combinations and alternatives.

Profitability Index = NPV Investment

Decision rule: Choose the combination of projects with the highest weighted-average PI.

2) Equivalent Annual Cash Flows

Sometimes it is useful to transform the present value of an investment into a stream of equal future cash flows. (e.g. when choosing between projects with different lengths).

The Equivalent Annual Cash Flow (EAC) of a project is the equal cash flow per period with the same present value as the actual cash flows of the project.

When the cash-flows are costs, this quantity is called the Equivalent Annual Cost.
where
EAC = PV(cash flows)/ annuity factor

annuity factor = 1 − (1 + r)^−n / r