Week 2 - Capital Budgeting Continued

Question 1

What adjustments need to be made to Free Cash Flow (FCF) to be accurate? What is the abbreviation for remembering the adjustments to be made? What do we ignore?

Answer 1

OCD - STT

• Capital Expenditure
• Depreciation
• Opportunity cost
• Salvage Value
• Terminal value
• Tax-loss carried forward

We ignore sunk costs.

Question 2

What is the ‘Cost of Capital’ the same as?

Answer 2

The discount rate reflects the Cost of Capital

Question 3

What is the ‘Discounted cash flow’?

Answer 3

Discounted Cash Flow tells you the current value of an investment after making adjustments for the ‘Time value of Money’.The discounted cash flow is essentially the Net Present Value but doesn’t subtract the initial outlay of the investment.

NPV = Initial cash outlay - DFC

Question 4

What is the process for calculating capital gains when dealing with ‘Liquidation or salvage value’?

Answer 4

• Book Value = Purchase price - Accumulated depreciation
• Gain on sale = Sale Price - Book Value

After-tax cash flow from asset sale = Sale Price - (Tax rate x Gain on sale)

Question 5

What is the Terminal Value of a Project?

Answer 5

The cash generated from a project after the forecasting period ha concluded

Question 6

What are the two ways Terminal Value can be calculated ?

Answer 6

Perpetual Growth model - (The business/project continues to grow at a fixed rate indefinitely)

Exit Multiple - (The business/project is sold after the forecasting period for a multiple of some market metric)

Question 7

What is the formula to calculate ‘Terminal Value’ for a firm with continuous growth?

Answer 7

Terminal Value = FCF(Desired year of value) x (1+g)/ r-g

Question 8

What types of errors could occur in NVP estimates and what are they?

Answer 8

Type l Error (A good project is rejected and shouldn’t have been)
Type ll Error (A bad project is accepted and shouldn’t have been)

Question 9

What three factors contribute to increased uncertainty when analysing a project?

Answer 9

• Overstated revenues
• Understated costs
• Tax increases

Question 10

3 Responses to uncertainty in project analysis

Answer 10

• Wait for uncertainty to be resolved.
• Reject investment
• Continue with investment

Question 11

What other methods of Analysis can be used?

Answer 11

• Break even analysis
• Sensitivity analysis
• Scenario analysis
• Elasticity

Question 12

What is Break-Even analysis in relation to project analysis?

Answer 12

The level at which the NPV of the project is equal to 0 (ZERO)

Question 13

What are the characteristics of Sensitivity analysis in relation to project analysis?

Answer 13

• Shows how changes in an ONE PARTICULAR input variable affect overall NPV.
• All variables are held constant EXCEPT one.
• If one variable is sensitive, more time should be spent ensuring the value of the variable is accurate.

Question 14

What are two advantages and two disadvantages of sensitivity analysis?

Answer 14

Advantages:
- Provides indication of stand-alone risk
- Identifies dangerous variables
Disadvantages:
- Ignores the relationship between variables
- Does not indicate if a risk is worth taking

Question 15

What is elasticity in relation to project analysis? And What is the equation for calculating elasticity?

Answer 15

Elasticity is the change in NPV relative to a 1% increase or decrease in a particular base value (variable). I.e. 1% above and 1% below

Elasticity = (NPV above base - NPV below base/Change in parameter) x Base P/Base NPV

Question 16

What is ‘Scenario analysis’ in regards to project analysis? And what scenarios are used?

Answer 16

Scenario Analysis examines NVP under several different situations to assess the impact of cash flows in different circumstances.

Worst case: Revenue low, Costs High
Base case: Expected revenue, Expected costs
Best case: Revenue high, costs low

Question 17

What are the ‘Managerial actions’ in capital budgeting?

Answer 17

• Can adapt after project starts.
• Contingency planning
• Option to expand
• Option to abandon
• Option to wait

Question 18

What is ‘Capital rationing’? And what two different forms does it take?

Answer 18

Firms have limited financial resources and must exercise rationing when selecting which and how many projects to undertake.

Soft rationing: the limited resources are self-imposed and temporary.
Hard rationing: capital will never be available for this project.

Question 19

What is the ‘Profitability Index’? And How is it calculated?

Answer 19

A ratio tool used to analyse the payoff of the investment against the projects costs.

Profitability index = Value Created/ Resources consumed

Question 20

What are ‘Projects with unequal Horizons’? And how is this issue fixed?

Answer 20

When comparing projects, their timelines will often be different. E.g. length of lease, physical life of asset.

When comparing projects, horizons need to be matched or ‘Equivalent Annual Benefit Method’ applied.

Question 21

At the start of a project what happens to inventory, accounts receivable and accounts payable?

Answer 21

Inventory - Increases (Buy stock)
Accounts Receivables - Decrease (collect Debt owed to you by customers)
Accounts Payables - Increased (Borrow Cash from a bank)

Question 22

What happens at the end of a project to Inventory, Accounts Receivables and Accounts payables?

Answer 22

Inventory - Decreases (Inventory sold)
Accounts Receivables - Increases
Accounts Payables - Decreases (pay back cash debt)