Module 9: Capital Budgeting

Question 1

figuring out what long-term projects a company should invest in

Answer 1

capital budgeting

(ex: should we choose to build a new factory, etc.)

Question 2

T or F: With capital budgeting, there’s limited resources so companies have to choose WHICH project to pursue.

Answer 2

True

Question 3

If we can invest in a project that’s going to return (more/less) than what we put into it, then we will do the project.

Answer 3

more

(if the PV of those future cash flows outweighs the cost, then we should do the project since NPV is the gold standard for capital budgeting)

Question 4

A cost that has already been incurred (something we’ve already paid).

Answer 4

Sunk Costs

Question 5

T or F: Paying for sunk costs depends on if you decide to do a certain project or not.

Answer 5

False; will pay for it whether or not we do the project

Question 6

We (do/do not) want to consider sunk costs when figuring out the relevant cost for a project.

Answer 6

do not

Question 7

we bought some land 2 years ago and now we’re trying to decide if we should build a new factory on the land. The price we paid for the land 2 years ago isn’t relevant for our decision because we already paid that.

This is an example of what type of cost?

Answer 7

Sunk cost

Question 8

Say we spent $700,000 on some land 2 years ago. This is a sunk cost, so we don’t want to consider it. BUT, let’s say we could sell that land today for $1.2 million.
This is an ________ ______ because if we don’t build on it, we could turn around and sell it, which is a relevant cost.

Answer 8

opportunity cost

Question 9

T or F: There is always an opportunity cost associated with a sunk cost.

Answer 9

False; NOT ALWAYS

(Ex: you spend $10,000 on a consultant to give you a report on how much a factory would cost. This is a sunk cost, but there’s not an opportunity cost associated with this. We probably can’t sell this report to anyone else or do something else with it, so that’s money that is just gone.)

Question 10

T or F: Oftentimes, for long-lived resources, there is an opportunity cost associated with sunk costs.

Answer 10

True

(ex: land)

Question 11

changes in other cash flows resulting from the project.

Answer 11

side effects (one of the relevant marginal cash flows)

Question 12

We (do/do not) want to include side effect costs in our analysis of the relevant cost for a project.

Answer 12

do

Question 13

Say we’re selling phones and thinking about releasing a new model. If we sell a new model, we will most likely sell less of the old model. So, the lost sales on the old model is a ______ ______ of releasing the new model.

Answer 13

side effect

Question 14

T or F: We do not want to include changes in net working capital in our analysis of the relevant cost for a project.

Answer 14

False; we DO want to include

(this includes all categories in net working capital, not just inventory. So like it includes accounts receivable, accounts payable, etc.)

Question 15

Typically, we will use (more/less) net working capital at the start of a project.

Answer 15

more

(but then we will get it back at the end of the project)

Although, there will be projects where we see this reversed!! But, whatever order, this will typically be reversed at the end of the project (so like if we start out with less net working capital at the start, we will typically use more NWC at the end)

Question 16

We start making widgets. So, we’ll need lots of parts to make them, so we’ll have an increase in inventory to start the project up. We spend $100,000 on all the inventory we need to build the widgets. Then, we’re gonna keep making widgets for 10 years, so we’re gonna have to keep that inventory high (every time we sell off widgets, we’re gonna have to buy more steel and wire, etc.) So, the money that we are spending on inventory is going to be tied up when we are doing the project. But then at the end, when the project is winding down (like we’re moving onto different things or whatnot), then we will use up the last of the inventory, and we will get that money back.

This is an example of what relevant marginal cash flow that’s used when analyzing the relevant cost of a project?

Answer 16

Changes in Net Working Capital

Question 17

We (do/do not) want to include taxes in our analysis of what the relevant cost is for a project.

Answer 17

DO want to include

This is cash flow we are not going to receive. (but just like with everything else, these are our MARGINAL taxes, not our total tax bill, but any increase or decrease in our taxes that’s going to result from doing the project is a relevant cash flow to include in the relevant cost for a project.

Question 18

Interest payments, dividends, and other things of that nature that are a result of financing are called _______ ______. We (do/do not) want to include this in our analysis of what the relevant cost for a project is.
^ Why?

Answer 18

• financing costs
• DO NOT
• because financing costs are already accounted for in our discount rate. (ex: if we count the interest costs directly, this would be like double counting once we get our PV and things like that)

Question 19

What is the formula for calculating Project Cash Flows?

Answer 19

Project Cash Flows = Project Operating Cash Flows - Project Change in Net Working Capital - Project Capital Spending

Question 20

In relation to the formula for calculating Project Cash Flows, how do you calculate the Project OPERATING Cash Flows for this formula?

Answer 20

Project Operating Cash Flows = any additional sales - any additional costs

Question 21

From an accounting perspective, how do you calculate Operating Cash Flows?

Answer 21

Operating Cash Flows = Earnings Before Interest and Taxes (EBIT) + Depreciation - Taxes

Question 22

What is the formula for Net Working Capital?

Answer 22

Current Assets - Current Liabilities

(Remember: Sources and Uses)

Question 23

Sources and Uses:
1. If there is an INCREASE in an asset, that is a (use/source) of cash.
2. If there is a DECREASE in an asset, that sis a (use/source) of cash.
3. If liabilities INCREASE, that is a (use/source) of cash.
4. If liabilities DECREASE, that is a (use/source) of cash.

Answer 23

1. use (like if you buy a car, you get the car asset but you use money to get it)
2. source (like if you sell a car, you get money from it)
3. source (like if you purchase something with your credit card, you now have more liability, but it gave you the cash to buy whatever you bought)
4. use (like if you pay down your credit card, this is a use of cash)

Question 24

If Net Working Capital goes down, this is a (source/use) of cash.

Answer 24

Source

(bc this means we’ve either decreased our current assets = source, or we’ve increased our current liabilities = also source)

Question 25

If Net Working Capital goes up, this is a (source/use) of cash.

Answer 25

Use

(bc this means we’ve either increased our current assets = use, or we’ve decreased our current liabilities= also use)

Question 26

T or F: Net Working Capital comes back at the end.

Answer 26

True
(easiest way to remember this is thinking in terms of inventory)

Question 27

How do you calculate the book value of an asset?

Answer 27

Purchase Price - Depreciation

(Depreciation is how we account for long term capital spending)

Question 28

What happens if you sell an asset for more than it’s book value?

Answer 28

You’ve got capital gains.

(means that we owe taxes, it’s like a profit)

Question 29

What happens if you sell an asset for less than it’s book value?

Answer 29

You’ve got capital loss.

Question 30

If you have capital (gains/loss) from selling an asset, this means you have reduced your tax liability.

Answer 30

loss

Question 31

What are the steps for calculating the after-tax salvage value? (3 steps)

Answer 31

1. Subtract book value from the price you sell the asset at. (Selling Price - Book Value)
2. Multiply that by the tax rate.
3. Subtract the answer you get from that from the original selling price which = after-tax salvage value.

Question 32

If we sell an asset for book value, there is no _____ ______.

Answer 32

tax effect (after-tax salvage value will just be the price we sold the asset at)

Question 33

If we sell an asset for MORE than it’s book value, this is a capital (gain/loss), which means the after-tax salvage value will be (larger/smaller) than what we sold the asset for.

If we sell an asset for LESS than it’s book value, this is a capital (gain/loss), which means the after-tax salvage value will be (larger/smaller) than what we sold the asset for.

Answer 33

• Gain; Smaller (we owe taxes, so we keep less than what we sold it for)
• Loss (so our tax liability is negative); Larger (tax benefit so our total value from the sale will be higher than what we sold it for)

Question 34

T or F: It’s always better to sell something for more than it’s worth (which is a capital loss), even if we have to pay more taxes on it, rather than selling it for less than it’s worth (which is a capital gain) and paying less taxes.

Answer 34

True

Question 35

T or F: Paying taxes later is better than paying taxes sooner.

Answer 35

True (because if you have a cost, you’d rather delay it than pay it today)

Question 36

What are the 2 ways to calculate depreciation?

Answer 36

1. Straight-Line Depreciation
2. Modified Accelerated Cost Recovery System (MACRS)

Question 37

a way to calculate depreciation by depreciating the same amount every year

Answer 37

Straight-Line Depreciation

Question 38

a table the government creates, where different assets fall into different “asset classes”, which tells you how much you can depreciate each year

Answer 38

Modified Accelerated Cost Recovery System (MACRS)

Question 39

With MACRS, we will take (larger/smaller) depreciation amounts early on.

Why do companies like to do this?

Answer 39

• larger
• bc the more we can depreciate sooner, the more it allows us to write down earlier taxes rather than later taxes

Question 40

What is the formula to calculate annual depreciation when doing straight-line depreciation?

Answer 40

Annual Depreciation = (Purchase Price - Ending Book Value) / Number of Years

Question 41

With MACRS depreciation:
- it always depreciates to ______.
- always assumes asset is purchased _______ through the _____ year.
- we assign to the appropriate _______ ______ and then use the table.

Answer 41

• $0 (there is no salvage value at the end)
• halfway; first (only get ½ a year of depreciation in that 1st year)
• property class

Question 42

What are the 2 things you can calculate from a MACRS depreciation schedule?

Answer 42

1. Depreciation
2. Ending Book Value

Question 43

How do we decide if we want to pursue a project with NPV?

Answer 43

If NPV is positive

Question 44

What are the 3 main types of risk analysis?

Answer 44

1. Sensitivity Analysis
2. Scenario Analysis
3. Simulations (also called Monte Carlo simulations)

Question 45

Which main type of risk analysis does this describe:
when we change one or two inputs at a time (like the numbers in an example) to see how it affects the result (which is the NPV; like whether or not we should do the project)

Answer 45

Sensitivity Analysis

Question 46

T or F: Simulations allows us to figure out which inputs are important for getting that positive NPV and making a decision on a project, and which inputs to focus on getting correct when estimating rather than getting just a rough estimate.

Answer 46

False; the SENSITIVITY ANALYSIS allows us…

Question 47

Which main type of risk analysis does this describe:
when we change a bunch of inputs all at once to see how it affects the result.

Answer 47

Scenario Analysis

Question 48

T or F: For scenario analysis, if it’s positive NPV in even the worst case scenario, then it’s a pretty safe project, assuming that our estimates are reasonable. But, if it’s only a good project in our best case scenario, then it is probably a less secure project.

Answer 48

True

Question 49

What are the 2 ways to use scenario analysis?

Answer 49

1. Generically (best case scenario, worse case scenario, etc.)
2. Specific scenarios (like if a law passes or not, how this would affect our project, etc.)

Question 50

What main type of risk analysis does this describe:
when we randomly draw inputs from a distribution and estimate thousands or millions of potential outcomes; looking at a range of a whole bunch of different combinations of inputs we could potentially wind up with and how this affects NPVs

Answer 50

Simulations

Question 51

All of the risk analyses are dealing with the fact that we’ve got ________, so even doing risk analysis doesn’t always give you a definite answer as to whether or not you should do a project.

Answer 51

uncertainty

Question 52

T or F: With Monte Carlo Simulations, if 90% of the time, we have a positive NPV, assuming the inputs are good, this tells us this is likely to be a good project.

Answer 52

True