Reading 25: Corporate Finance Flashcards
Calculate the yearly cash flows of expansion and replacement capital projects, and evaluate how the choice of depreciation method affects those cash flows.
Expansion:
- Initial Outlay = FCInv + WcInv
- CF = (S - C - D) x (1 - T) + D
- TNOCF = Sal + NWCInv - T ( Sal - BV)
Replacement:
- Current after-tax salvage value of the old assets reduces the inital outlay
- Depreciation is the change in depreciation if the proejct is accepted compared to the depreciation of the old machine
ACCELERATED DEPRECIATION LEADS TO A HIGHER PROJECT NPV
Explain the effects of inflation on capital budgeting analysis.
- Nominal CFs must be discounted at the nominal interest rate, and real cash flows must be discounted at teh real interest rate
- Unexpected changes in inflation affect project profitability
- Inflation reduces the real tax savings from depreciation
- Inflation decreases the value of fixed payments to bondholders
- Inflation affects costs and revenues differently
Evaluate capital projects and determine the optimal capital project in situations of (1) mutually exclusive projects with unequal lives, using either the least common multiple of lives approach or the equiavlent annual annuity approach, and (2) capital rationing.
Least common multiple of lives: make the lives of the projects equal to each other
Equivalent annual annuity: calculate the PMT of each project and compare
Explain how sensitivity analysis, scenario analysis, and Monte Carlo simulation can be used to assess the stand-alone risk of a capital project.
- Sensitivity: varying an independnet variable to see how much the dependent variable changes, all other things held constant
- Scenario: sensitivity of the dependent variable to simultaneous chagnes in all of the independent variables
- Simulation: repated random draws
Explain and calculate the discount rate, based on market risk methods, to use in valueing a capital project.
The CAPM can be used to determine the appropriate discount rate for a project based on risk. The project beta, B, is used to measure of the systematic risk of the project, and the security market line (SML) estimates the required return.
Describe types of real options and evaluate a capital project using real options.
- Timing Options: delay making an investment
- Abandonment: allow an exit
- Expansion: add-on later in the process
- Flexibility: price-setting & production
- Fundamental: payoffs depend on price of an underlying asset
Describe common capital budgeting pitfalls.
- Failing to incorporate economnic resopnses
- Misusing standardized templates
- Overly optimsitic assumptions
- Based on short-term EPS or ROE goals
- Using IRR criterion for project decisions
- Poor cash flow estimation
- MIsestimation of overhead costs
- Using a discouint rate that does not accuratly reflect the projects risk
- Politics involved with spending the entire budget
- Failure to generate alternative investment ideas
- Improper handling of sung and opportunity costs
Calculate and interpret accounting income and economic income in the context of capital budgeting.
- Economic Income: after-tax cash flows plus the change in the projects market value
- Accounting Income: revenues minues costs of the projects
Two key principles
- 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.
- 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.
Distinguish among the economic profit, residiual income, and claims valuation models for capital budgeting and evaluate a capital project using each.
- Economic Profit: NOPAT - $WACC
- Residual Income: Net Income - Equity Charge
- Claims Valuation: separates cash flows based on the claims that equityholders and debtholders have on the asset. CF are respectively discounted by cost of debt or equity. The PV equals the company value.
