Week 10 Capital Budgeting II Flashcards
What is capital budgeting?
The process used to analyse alternate projects and decide which one(s) to accept or reject
What is the goal of capital budgeting?
Determine the effect of the accept/reject decision on the firm’s cash flows
What is the usual process of capital budgeting?
Evaluate the NPV of these cash flows to assess
How do you treat the cash flows in calculating NPVs?
- Use cash flows, not accounting income
- Ignore sunk costs
- Include OC
- Include side effects
- Include working capital
- Include taxation impacts
- Exclude financing costs
- Take care with inflation
What are free cash flows?
The incremental effect of a project on a firm’s available cash
Why do we not use accounting income when calculating NPV?
It is based on arbitrary revenue and expense recognition rules used by accountants
What is an example of something included in accounting income?
Capital expenditure - arbitrarily expensed (depreciated) over the life of the project in the calculation of accounting income
How do you calculate Free Cash Flow (FCF)?
Operating cash flow - Capital expenditures - Increase in working capital requirements
How do you calculate operating cash flow?
Revenues - Cash expenses - taxes OR EBDIT - Taxes
How do you calculate working capital requirements?
Current year’s working capital requirements - previous year’s working capital requirement
What are cash expenses?
Accounting costs that result in cash outflows: eg. Cost of Goods Sold (COGS), general and administrative expenses
What are some examples of cash expenses?
Cost of goods sold (COGS), general and administrative expenses
Is depreciation expense a cash expense?
No
How do you calculate taxes?
Taxes = earnings before interest and taxes (EBIT) * taxation
What are sunk costs?
Any costs that will be incurred regardless of whether you accept or reject the project
Why are sunk costs irrelevant to decision making?
They are not incremental cash outflows. Even if they have been incurred as a direct result of evaluating the project because they have been (or will be) incurred regardless of whether or not the project goes ahead.
What are overhead costs?
They are a type of sunk cost - they are costs which are incurred by the firm but cannot be attributed to a specific project
What is an opportunity cost?
Opportunity costs occur when a resource is used in a project that could otherwise be put to some productive use.
How do we include opportunity costs in calculating NPV?
The dollar value of the best alternative use must be included as a cash outflow in calculating the NPV because the opportunity cost is ‘consumed’ in undertaking the project
What is a side effect?
A positive or negative cash flow that relates to other aspects of a company’s business as a result of implementing the project.
What are some types of side effects?
Positive and negative incidental effects of externalities
What is working capital?
Funds set aside to ensure that the company has sufficient cash flows to maintain operations whilst undertaking the project
How do you calculate net working capital?
change in net working capital = change in current assets - change in current liabilities
Why does working capital have to be included in cash flow calculations?
It has an opportunity cost
How is working capital included in NPV calculations?
Most projets will require an investment in net working capital at the onsent that should be recognised as a cash outflow in cash flow forecasts. When the project comes to an end, one can usually recover all or some of this investment, which results in a cash inflow
What is taxation?
Taxation represents a cash outflow and needs to be included in calculations
What role does taxation play in calculating cash flows?
Cash flows should be estimated on an after-tax basis. After tax cash flows must be discounted using an after-tax required rate of return.
How can tax influence projects?
a. corporate income tax
b. depreciation –> tax deduction = tax shield
c. Liquidation or salvage value
What is depreciation?
Depreciation is deducted when calculating the taxable income but is not an actual cash flow
What is the effect of depreciation?
The only effect of depreciation is to reduce the tax payable. Therefore it acts as a ‘tax shield’.
What are some other tax considerations?
- Assets that are no longer needed can be sold
- Need to adjust project’s free cash flows to account for after-tax cash flow that would result from liquidation of asset
What is taxable capital gain?
If an asset is sold for a price higher than its current book value, then the difference is treated as a taxable cpaital gain. This is a reflection of the fact that the aset was over depreciated in the first place.
What is capital loss?
If an asset is sold for a price lower than its current book value, then the difference is treated as a capital loss. This creates a deduction for taxable income that can be used elsewhere in the company.
How do you calculate capital gain?
Capital gain = sale price - book value
How do you calculate book value?
Book value = original purchase price - accumulated depreciation
How do you calculate tax on asset sale?
Tax on asset sale = -(sale price - book value) x tax rate
What are financing costs?
All cash flows associated with financing a project are ignored
How does a company determine how to finance a project?
The companhy must assess if the project is value increasing before determining how to finance it
What is the effect of inflation on cash flows?
Inflation can reduce the purchasing power of future cash flows.
How do you apply inflation to calculation questions?
Be consistent in how inflation is treated. Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows
What is Fisher’s effect?
(1+rn) = (1+rr)*(1+p)
where:
rn = nominal rate of return
rr = real rate of return
p = inflation rate
