Week 3

Question 1

What is capital budgeting?

Answer 1

Capital budgeting is the process that companies use for decision making on capital projects, that is, investments in non-current assets. Capital budgeting involves evaluating the size of future cash flows, the timing of future cash flows, and the riskiness of future cash flows.

Question 2

What are the types of capital projects?

Answer 2

The types of capital projects are: replacement projects, expansion projects, new products and services, regulatory, safety and environmental projects, and more

Question 3

What are the main potential sources of cash flows?

Answer 3

Cash flows come from sales and other revenues, the cost of sales and expenses, depreciation, working capital, and taxes.

Question 4

How do revenues affect cash flows?

Answer 4

Revenue contributes to cash flows positively by a factor of (1-tax rate).

Question 5

How does depreciation affect cash flows?

Answer 5

Depreciation is not a real cash flow, however it provides a tax shelter and tax savings, this means depreciation affects cash flows positively by reducing taxable income. The depreciation tax shield equals the depreciation expense * the tax rate, and adds that much to the cash flow.

Question 6

What are the two methods of calculating depreciation?

Answer 6

The prime cost (straight line) method, and the reducing balance(diminishing value) method.

Question 7

How does the prime cost method of calculating depreciation work?

Answer 7

The prime cost(straight line) method of computing depreciaiton applies a constant rate to the asset’s initial cost to identify allowable deduction each year, this means depreciation = the depreciation rate * the initial book value.

Question 8

How does the reducing balance (diminishing value) method of calculating depreciation work?

Answer 8

The reducing balance (diminishing value) method applies a constant rate to the assets beginning of year book value to identify the allowable deduction each year, this means depreciation is a variable amount which declines over time. In this case, depreciation at time t = the depreciation rate * the book value at time t-1.

Question 9

What is net working capital? What is it used for? What occurs at the end of the project?

Answer 9

The net working capital is the difference between current assets and current liabilities. It is the cash employed to run day-to-day operations of a firm, it is not consumed but rather employed for a period of time. An increase in working capital during a period means more cash is employed, which is a cash outflow. A decrease in working capital during a period means less cash is employed, this is a cash inflow.
The working capital is normally assumed to be recovered at the end of the project (a cash inflow).

Question 10

What are the major impacts of taxation on cash flows?

Answer 10

Taxation has three major impacts:

1. Income tax represents a cash outflow.
2. Tax shield - depreciation provides a tax deduction which results in a tax saving.
3. Capital gains tax lowers the net profit received from the sale of an asset and may result in a tax saving when a loss is made from the sale of an asset.

Question 11

What are the two possibilities of tax with relation to the sale of an asset?

Answer 11

Generally the sale of an asset generates a gain/profit or a loss (if sold for less than book value), a gain is subject to tax, while a loss will result in a tax deduction.

Question 12

What are the three potential approaches for calculating cash flows?

Answer 12

The three potential approaches for calculating operating cash flows are top-down, bottom up, or tax shield.

Question 13

How do we use the top-down approach for calculating operating cash flows?

Answer 13

The top-down approach for calculating operating cash flow is: revenue - cash costs -taxes. 
Taxes is (revenue - costs - depreciation)*tax rate.

Question 14

How do we use the bottom-up approach to calculate operating cash flows?

Answer 14

The bottom-up approach is revenue - expenses - depreciation*(1-tax rate) + depreciation.

Question 15

What are some important things to remember with regards to discounting, and the estimation of cash flows?

Answer 15

When discounting, only cash flow is relevant, we should always estimate the cash flows on an incremental basis, and be consistent in our treatment of inflation.

Question 16

Should we include sunk costs?

Answer 16

We should ignore sunk costs as they are cash outflows that were incurred in the past and are no longer relevant to influencing whether a prospective project should be undertaken.

Question 17

What are opportunity costs with relations to projects? What about side effects?

Answer 17

We need to account for opportunity costs, and side effects in our project analysis. opportunity costs are our lost revenues due to alternative uses. We should take these away from our cash flows.
Side effects can have a positive (synergy), in which case a new project increases cash flows of existing projects, or be negative (erosion), in which case a new project decreases cash flows of existing projects.

Question 18

Should we include existing costs in our project analysis?

Answer 18

We shouldn’t allocate existing overheads (fixed costs) we should only assign any change in fixed costs to a proposed project.

Question 19

Do we need to include changes in net working capital in our analysis? How can they occur?

Answer 19

We must remember to include any change in net working capital, this could occur due to extra stocks of raw materials and work in progress to support the manufacturing operations, or additional stocks of finished goods and debtors to support the selling function.

Question 20

Should we include interest costs in our project analysis?

Answer 20

Interest/financing costs should not be included as an explicit cash flow because interest costs are included in the required rate of return (discount rate / cost of capital) to evaluate the project, if the project’s NPV is positive the cash flows from the investment will cover interest costs.

Question 21

What is important with regard to real and nominal interest rates and calculating cash flows?

Answer 21

Nominal cash flows should be discounted at the nominal rate, real cash flows must be discounted at the real rate.

Question 22

What equation relates the nominal interest rate and real interest rate?

Answer 22

(1+nominal rate_ = (1+ Real rate)*(1+expected inflation).

Question 23

What are the three major periods in terms of cash flows?

Answer 23

In a typical project the initial outlay involves things like purchasing equipment, initial development costs, and an increase in net working capital. It will have ongoing cash flows coming in the form of incremental revenues, incremental costs, taxes, and changes in net working capital. Finally it has terminal cash flows, these consist of sale of equipment, shutdown costs, and a decrease in net working capital.

Question 24

How do we calculate the initial cash outflow?

Answer 24

The initial cash outflow is the initial net cash investment, to calculate the initial cash outflow:
Cost of new assets + capitalized expenditures +(-) the increase(decrease) in net working capital - net proceeds from sale of asset(s) if replacement +(-) tax(savings) due to sale of old asset(s) if replacement.

Question 25

How do we calculate the incremental cash flows?

Answer 25

Incremental cash flows are the net cash flows occurring after initial cash investment but not including the final period’s cash flow.
To calculate the incremental netcash flow for a period: Net increase(decrease) in operating revenue -(+ any net increase (decrease) in operating expenses, excluding depreciation -(+) the net increase(decrease) in depreciation charges.
This gives us the net change in income before taxes, we then subtract the net increase in taxes, giving us the net change in income after taxes, and then add the net increase in depreciation charges. This will give us the net cash flow for the period.

Question 26

How do we calculate the final period’s incremental after-tax net cash flow?

Answer 26

The final period’s incremental after-tax net cash flow, it is usually in the final year, but may extend to several years at the end of the project.
To calculate the terminal-year incremental after-tax net cash flow:
Incremental net cash flow for terminal period + salvage value of any sold or disposed assets - taxes due to asset sale or disposal of new assets + decrease in net working capital.

Question 27

What is one of the main cases where NPV struggles? How can we fix this?

Answer 27

The simple net present value method may provide the wrong decision if the project lives are unequal and mutually exclusive, as such we need to somehow equalize the lives of the different projects, which we do using the replacement chain assumption, this assumption is that we replicate at the end of a project’s life with a replacement project with identical cash flows to the original.

Question 28

What are the three methods that make use of the replacement chain assumption? How do they work?

Answer 28

We can use the lowest common multiple (life) method, the NPV in perpetuity method (replication repeats to infinitely for perpetuity) or the equivalent annual annuity method. The NPV can then be evaluated over the identical period for both projects or over an infinite period.

Question 29

How does the lowest common life method work?

Answer 29

The lowest common life method calculates the net present value over the lowest common life period for the two projects. This is done by using the replacement chain assumption for each project so that the life period is euql to the lowest common life period. We will know the NPV for each individual project part and as such can same time by just summing the discounted “repeat” NPVs.

We then pick the project with the highest NPV.

Question 30

What year does the initial cash flow for the replacement project go under the replacement chain assumption?

Answer 30

When using the replacement chain assumption the initial cash flow for the replacement goes in the final year of the original project and so on.

Question 31

How does the constant chain of replacement method work?

Answer 31

The constant chain of replacement (NPV in perpetuity) method assumes both chains of the replacement continue indefinitely. We calculate this infinite NPV as the net present value of the original project * (((1+r)^n)/((1+r)^n -1)).
where r is the required rate of return and n is the lifespan of the original project.
We then select the project with the largest NPV.

Question 32

How does the equivalent annual annuity method work?

Answer 32

To use the equivalent annual annuity method, we consider an annuity of C dollars per period for n periods, when interest rate is r. This gives a present value of C*PVIFA_r,n.
Then for a project with NPV, its equivalent annual constant cash flow(annual equivalent value) is AEV = NPV/PVIFA_n,r.
If we are considering costs, then the annual equivalent cost is AEC = cost/PVIFA_n,r.
A greater annual eivalent value(smaller annual equivalent costs) is better.

Question 33

What is PVIFA_r,n?

Answer 33

PVIFA_r,n is the present value interest factor annuity. It is the present value of an annuity of $1 per period for n periods, at discount rate r.

It is equal to the annuity formula with a cash flow value of 1.

Question 34

Which is the best replacement chain assumption method to use? What are some of the problems?

Answer 34

When we have identical required returns on different projects the lowest common life, constant chain of replacement, and equivalent annual annuity method will give the same accept or reject decision.

However, lowest common life and constant chain of replacement may give different signals when the rate of return required differs, and the AEC/AEV is not appropriate when required rates of returns differ.
In general the constant chain of replacement method is preferred.

Question 35

What is the main problem with the equivalent annual annuity method?

Answer 35

The equivalent annual annuity method assumes projects will be repeated, so we should only use it if there is a reasonable probability of replicating projects, and projects have significantly different lives.