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CFA Level II Corporate Finance > Reading 25 - Capital Budgeting > Flashcards

Reading 25 - Capital Budgeting Flashcards

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1
Q

What are the 3 components for an Expansion Project?

A
  1. Initial investment outlay
  2. After-tax operating cash flows
  3. Terminal year after-tax non-operating cash flow (TNOCF)
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2
Q

What figures are included in the Initial Investment Outlay?

A

It may include the purchase price plus transportation and installation costs, additional costs such as training, and any increase in net working capital.

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3
Q

What is the formula to determine the amount of the **Initial Investment Outlay **for a new investment(project)?

***Critical Concept******

A

= FCInv + NWCInv

FCInv = includes purchase price, shipping & installation

NWCInv = ∆non-cash current assets - ∆non-debt current liabilities

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4
Q

How do you calculate the After-tax operating cash flow (CF)?

***Critical Concept******

A

Sales

-Cash Operating Expenses

-Depreciation

=Operating Income before taxes

-Taxes on Operating Income

=Operating Income After Taxes

+Depreciation

=After Tax Operating Cash Flow

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5
Q

How do you calculate the Terminal year after-tax non-operating cash flow (TNOCF) ?

***Critical Concept******

A

TNOCF= SalT +NWCInv-T(SalT -BT)

SalT = cash proceeds from sale of fixed capital

BT = book value of fixed capital

T = marginal tax rate

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6
Q

The cash flow estimation for Replacement Projects is similar to Expansion Projects, what two additional things that must be done for Replacement Projects?

A
  1. You must reduce the initial outlay by the after-tax proceeds of the sale of the existing asset.
  2. You must use only the change in depreciation that results from replacement.
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7
Q

What are some points to remember when estimating incremental after-tax cash flows?

A
  1. Ignore sunk costs
  2. Ignore any financing costs associated with asset purchase.
  3. Include any effects on the cash flows for other firm products (externalities)
  4. Include the opportunity cost of using any existing firm assets for the project
  5. Shipping and installation costs are included in the initial cost used to calculate the annual depreciation for new assets.
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8
Q

For mutually exclusive projects with unequal lives, you cannot simply use the NPV. What are the two approaches to put projects on an equal basis timewise?

A
  1. Replacement chain approach(aka Least Common multiple of lives approach) - Assume the short project can be repeated until ending at the same time as the longer project, then compare NPVs.
  2. Equivalent Annual Annuity (EAA) Approach - converts the NPV for each project into an equivalent annual payment and you select the project with the greater (+) equivalent annual payment.
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9
Q

What are the steps in using the Equivalent Annual Annuity (EAA) approach ?

A
  1. Find each project’s NPV
  2. Find an annuity (EAA) with a present value equal to the project’s NPV over its individual life at the WACC
  3. Select the project with the highest EAA.
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10
Q

How is the annuity figure actually calculated using the EAA approach?

****Critical Concept******

A

Simple, just plug number into the TVM calc

N = # of yrs of the project

I = required return of the project

PV = negative amount of the already calculated NPV

PMT = this is what we are solving for!!!!

FV = 0

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11
Q

What are the 3 techniques for estimating the risk of a capital investment/project ?

A
  1. Sensitivity Analysis : involves changing a variable and recalculating the NPV. The project with a greater % change in NPV for a given variable change is the riskier project.
  2. Scenario Analysis : Calculate the NPV for “base-case” , worst-case and a best-case scenario and assign probabilities to each of those outcomes.Then calculate the standard deviation of the NPV as you would with any probability model.
  3. Monte Carlo Simulation : Use assumed probability distributions for the key variables in the NPV calculatio, draw random values for these variables and calculate NPV (1,000’s of times), and use the distribution of NPV’s to estimate the expected NPV
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12
Q

What is Capital Rationing?

A

Is the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth.

**The goal is to maxmize the overall NPV within the capital budget, not necessarily to select the individual projects with the highest NPV.

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13
Q

What is the formula using CAPM to determine the discount rate for a project?

A

Rproject = Rf + ßproject [E(RM) - RF]

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14
Q

What are Real Options in regards to capital budgeting ?

A

Similar to financial call and put options in that they give the option holder the right, but not the obligation, to make a decision.

**Real Options are based on real assets rather than financial assets and are contingent on future events

**Real Options offer managers flexibility that can increase the NPV of individual projects.

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15
Q

What are the 5 types of Real Options?

A

FFEAT

  1. Fundamental options
  2. Flexibility options
  3. Expansion options
  4. Abandonment options
  5. Timing options
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16
Q

What are the 4 approaches to evaluating the profitabilty of Real Options?

A
  1. Determine the NPV of the project without the option
  2. Calculate the projects NPV without the option and add the esitmated value of the real option
  3. Use decision tree
  4. Use option pricing models.
17
Q

What is Economic Income?

******Critical Concept******

A

equal to the after-tax cash flow plus the change in the investment’s market value.

**interest is ignored and is instead included as a component of the discount rate

economic income = after-tax cash flow - economic depreciation

economic depreciation = (beg mv - end mv)

18
Q

What is Accounting Income?

A

The reported net income on a company’s financial statements that results from an investment in a project

19
Q

What are the 2 key factors that account for the differences between economic and accounting income?

*******Critical Concept**************

A
  1. Accounting depreciation is based on the original cost of the investment, while economic depreciation is based on the change in market value of the investment
  2. The after-tax cost of debt (interest expense) is subtracted from net income, while financing costs for determining economic income are reflected in the discount rate.
20
Q

What are the three other valuation models for capital budgeting ?

A
  • Economic profit is calculated as NOPAT − $WACC. Economic profit reflects the income earned by all capital holders and is therefore discounted at the WACC to determine the market value added (MVA) or NPV of the investment.
  • Residual income is focused on returns to equity holders and is calculated as net income − equity charge. Residual income reflects the income to equityholders only and is discounted at the required return on equity to determine NPV.
  • Claims valuation separates cash flows based on the claims that equityholders and debtholders have on the asset. Cash flows to debt holders are discounted at the cost of debt and cash flows to equity holders are discounted at the cost of equity. The present value of each set of cash flows is added together to determine the value of the company.
21
Q

What are the different categories capital budgeting projects may be divided into ?

A
  1. Replacement projects to maintain the business
  2. Replacement projects for cost reduction
  3. Expansion projects
  4. New product or market
  5. Mandatory projects
  6. Other projects
22
Q

What are the 5 key principles of the capital budgeting process?

A
  1. Decisions are based on cash flows, not accounting income
  2. Cash flows are based on opportunity costs
  3. The timing of cash flows is important
  4. Cash flows are analyzed on an after-tax basis
  5. Financing costs are reflected in the project’s required rate of return
23
Q

What is MACRS ?

A

Modified Accelerated Cost Recovery System

**Under MACRS, assets are classified into 3, 5, 7 or 10 yr classes and each year’s depreciation is determined by specific recovery percentages

24
Q

What is Depreciable basis?

******Critical Concept***********

A

is equal to the purchase price plus any shipping or handling and installation costs.

25
Q

Explain the effects of inflation on capital budgeting analysis…..

A
  1. Analyzing nominal or real cash flows
  2. Changes in inflation affect project profitability
  3. Inflation reduces the tax savings from depreciation
  4. Inflation decreases the value of payments to bondholders
  5. Inflation may affect revenues and costs differently
26
Q

What are Hard Capital Rationing & Soft Capital Rationing?

A

Hard Capital Rationing - occurs when the funds allocated to managers under the capital budget cannot be increased.

Soft Capital Rationing - occurs when managers are allowed to increase their allocated capital budget if they can justify to sr management that the additional funds will create shareholder value

27
Q

What are the common mistakes managers make when evaluating capital projects ?

A
  1. Failing to incorporate economic responses into the analysis
  2. Misusing standardized templates
  3. Pet projects of senior management
  4. Basing investment decisions on EPS or ROE
  5. Using the IRR criterion for project decisions
  6. Poor cash flow estimation
  7. Misestimation of overhead costs
  8. Using the incorrect discount rate
  9. Politics involved with spending the entire capital budget
  10. Failure to generate alternative investment ideas
  11. Improper handling of sunk and opportunity costs
28
Q

What is NOPAT & how is it calculated?

*****Critical Concept********

A

Net Operating Profit After Tax

= EBIT * ( 1 - T )

29
Q

How do you calculate Economic Profit?

****Critical Concept*****

A

EP = NOPAT - $WACC

NOPAT = Net operating Profit After tax , aka EBIT*(1-T)

$WACC = dollar cost of capital * capital

30
Q

How do you calculate the ‘capital’ portion of the Economic Profit formula?

A

The initial investment reduced by depreciation for each yr.

31
Q

Describe how NPV, Economic Profit and Market Value Added (MVA) are related?

A

To calculate Market Value Added you just calculate the NPV of an asset’s Economic Profit over time…

32
Q

What is Residual Income and how is it calculated?

****Critical Concept****

A

Residual income focuses on returns on equity

As such:

RI = Net Income - equity charge

Equity Charge = required return on equity * beginning period book value of equity

33
Q

How is the value of an option calculated?

A

CFA Level II Corporate Finance (6 decks)

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