R.20 Capital Budgeting

Question 1

Basic principals (5)

Equation Format for Organizing Cash Flows

Answer 1

Basic principals (5)

1. Decisions are based on cash flows, not accounting concepts like NI. Intangible costs/benefits are often ignored bc they should result in cash flows at some other time.
2. Timing of cash flows is crucial. Analysts make an extraordinary effort to detail precisely when cash flows occur.
3. Cash flows are based on opportunity costs. What are the incremental cash flows that occur with an investment compared to what they would have been without the investment?
4. Cash flows are analyzed on an after-tax basis. Taxes must be fully reflected in all capital budgeting decisions.
5. Financing costs are ignored

Equation Format for Organizing Cash Flows

1. Initial outlay (IO)
2. Annual after-tax operating cash flow (ATOCF)
3. Terminal year after-tax non-operating cash flow (TNOCF)

Question 2

1. Initial outlay (IO)

Answer 2

Question 3

2. Annual after-tax operating cash flow (ATOCF)

Answer 3

Question 4

3. Terminal year after-tax non-operating cash flow (TNOCF)

Answer 4

Question 5

Capital Budgeting example Q&A for IO, ATOCF, and TNOCF

Answer 5

Question 6

Explain how inflation affects capital budgeting analysis.

Answer 6

LOS 23.b

Discount rate - real WACC would be lowered by the inflation rate:
WACC_real = WACC_nominal - R_inflation

Affects profitability - If inflation higher than expected, future cash flows are worth less, so NPV is lowered

Reduces tax savings (tax sheild) - higher than expected lowers the depreciation charge

Decreases payments to bondholders - higher than expected inflation shifts wealth to issuing firms at bondholders’ expense

May affect revenues and costs differently - alters ATCFs

Question 7

Describe two ways to evaluate mutually exclusive projects with unequal lives

Answer 7

LOS 23.c

Least common multiple of lives “replacement chain” - compute NPV for the two projects, then combine and discount iterations of each of the two projects to compute NPV for comparison

Equivalent annual annuity (EAA) - using calculated NPV for each project, compute the effective annuity payment over each project’s time span that equals the each project’s NPV. Higher payment is the more valuable project.

Question 8

Describe Capital Rationing and how to choose projects under limited capital resources

Answer 8

LOS 23.c

Capital rationing - the allocation of limited fixed capital to a set of available projects that maximizes shareholder wealth.

Hard capital rationing - available capital to managers cannot be increased

Soft capital rationing - additional capital can be allocated to managers if shareholder wealth can be increased as result.

Question 9

Explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the stand-alone risk of a capital project

Answer 9

LOS 23.d

sensitivity analysis - change one input variable (+/-) to see how the base case is effected. Note the high and low influence input (independent) variables

scenario analysis - construct probable scenarios and assign values to many input variables. One could compute a weighed average of the scenario outcomes

Monte Carlo simulation - assign a probability distribution to each input variable and run many random input scenarios. Compute NPV mean, NPV standard deviation, and NPV correlation with each input variable

Question 10

Explain and calculate the discount rate (using market risk methods) to use in valuing a capital project

Answer 10

LOS 23.e

Important points:

• Project beta is appropriate for measuring project /asset risk when a company (or its shareholders) are diversified.
• CAPM (or SML) is used to setermine discount rate for the asset/project.

R_project = R_F + B_project [E(R_MKT) - R_F

• Using a project’s beta to determine project-specific discount rate (also called “hurdle rate”) is important when the project’s risk is different from the company’s overall risk.

Question 11

Describe common capital budgeting mistakes

Answer 11

LOS 23.g

• failing to incorporate industry reaction to the project
• misusing standard templates
• pet projects - overly optimistic projections; less analysis
• basing decisions of ROE or EPS - EPS/ROE incentives cause it
• using IRR instead of NPV
• poor cash flow estimation
• poor overhead cost estimation - consider only incremental overhead costs related to management time and IT support
• using incorrect discount rate e.g. company WACC instead of rate based on project’s risk
• politics of manager spending entire annual budget
• failure to generate alternative ptojects - don’t stop at “good” when there could be “better”
• improper use of sunk and opportunity costs

Question 12

Economic Income (of a project)

Answer 12

LOS 23.h

Economic Income - one of two measurement alternatives to the basic discounted incremental cash flow approach used in the standard capital budgeting model (the other is Accounting Income). Like the DIATCF budgeting model, interest expense is reflected in the discount rate.

Economic inc equals after-tax cash flow plus the change in the investment’s market value, where

d(investment’s mkt value) = PV(discounted remaing ATCF) at WACC

econ inc = ATCF + (end mkt value - begin mkt value), or

econ inc = ATCF - economic deperession, where
economic depression = (begin mkt value - end mkt value)

Question 13

Accounting Income (of a project)

• calc
• explanation
• why does it differs from economic income?

Answer 13

LOS 23.h

NI (accounting) = (S - C - I)(1 - T) + TD (plus ATSal_T for Year_T),

where I = (begin MV)(Int%_debt)(%debt used to finance proj)

Accounting Income - one of two measurement alternatives to the basic discounted incremental cash flow approach used in the standard capital budgeting model (the other is Economic Income). Accounting Income is the reported NI on a company’s financial statements that results from an investment in a project.

Project’s Accounting income differs from Economic income because…

• Accounting depreciation is based on the original cost (not market value) of the investment
• In accounting income, financing costs (e.g. interest expense) are considered as a separate line item and subtracted out to arrive at NI. In the basic capital budgeting model (and also the standard model) financing costs are reflected in the WACC.

Question 14

Market Value Added

Answer 14

LOS 23.i

market value added - the NPV based on economic profit. NPV using MVA is always the same as the valuation of NPV using the basic NPV approach.

NPV = MVA = sum[EP_t / (1+WACC)^t], where

EP_t = economic profit in year t

Question 15

Economic Profit

Answer 15

LOS 23.i

a measure of profit in excess of the dollar cost of capital invested in a project:

EP = NOPAT - $WACC, where

NOPAT = net operating profit after tax = EBIT(1 - T)
$WACC = dollar cost of capital = WACC \* capital
capital = dollar amount of investment (_initial investment reduced by depreciation each year_)

NOTE: “economic profit” and “economic income” refer to different concepts!

Question 16

Residual Income

Answer 16

LOS 23.i

residual income - focuses only on r_eturns to equityholders_ by subtracting an equity charge from the accounting NI:

residual income = NI - equity charge

or

RI_t = NL_t - r_eB_t-1, where

RI_t = residual income in period t

NI_t = net income in period t

r_e = required rate of return on equity

B_t-1 = beginning of period book value of equity.

So, NPV = sum[RI_t / (1+ r_e)^t]

Question 17

Claims Valuation Approach

Answer 17

LOS 23.i

claims valuation - based on BS concept that every asset is is financed by some combination of bedt and equity. divides operarating cash flows based on the claims of debt and equityholders that provide capital to the company, which are then added together to determine the value of the company (not the project).

• CF from debt = principle payments d(liab) + interest payments (from BS) discounted by the cost of debt.
• CF from equity = CFO (NI + deprec) - interest paid to bondholders d(liab).dividends and share repurchases discounted by cost of equity.