Outline the basic framework for capital expenditure analysis. - General Guidelines
1.Estimate all cash flows on an after-tax basis and use an after-tax discount rate.
2.Use appropriate cash flow estimates that represent the marginal or incremental cash flows arising capital budgeting decisions. These are the additional cash flows that result from capital budgeting decisions.
3.Do not include associated interest and dividend payments in estimated project cash flows; these should be accounted for in the discount rate.
4.Adjust cash flows to reflect any additional working capital requirements, particularly the initial outlay and the terminal cash flow.
5.Treat sunk costs, costs that have already been incurred and cannot be recovered regardless of the capital budgeting decision, as irrelevant. We are concerned only with future cash flows
6.Although sunk costs are irrelevant, opportunity costs should be factored into cash flow estimates. Opportunity costs are cash flows that must be forgone as a result of an investment decision.
7.Determine the appropriate time horizon for a project.
8.Ignore intangible considerations that cannot be measured unless their impact on cash flows can be estimated. Intangibles should not be used to justify poor projects.
9.Ignore externalities, which are consequences that result from an investment that may benefit or harm unrelated third parties.
10.Consider the effect of all project interdependencies on cash flow estimates. Undertaking a negative NPV project could lose money in the short-term, but give the firm the option to generate value in the future
11.Treat inflation consistently: discount nominal cash flows with nominal discount rates, or real cash flows with real discount rates.
12.Undertake all social investments required by law. Many social and infrastructure projects must be undertaken even though they have negative rates of return or no definable impact on the value of the firm.
The Initial After-Tax Cash Flow (CF0)
•All evaluation approaches (NPV, IRR, discounted payback and PI) require the same data:
CF0 = the estimate of the initial outlay
CFBT(1 – T) = the net incremental after-tax cash flows
k = the cost of capital
n = the estimate of the useful life
ECFn = the ending cash flow
T = the corporate tax rate
d = the Capital Cost Allowance rate
ESTIMATING AND DSICOUNTING CASH FLOWS
the initial after-tax cash flow (CFo) is
•The basic cash flow pattern has an initial investment and t = 0, an annual stream of after-tax cash flow benefits at each time period, and, at the end of the useful life, ending cash flow benefits after-tax
•The NPV is given by Equation 14-5:
What is marginal or Incremental cash flows
the additional cash flows that result from cpatial budgeting decisions, generated by new projects
what are sunk costs
costs that have already been incurrred, cannot be recovered, and should not influencence current capital budgeting decisions
what is opportunity cost
cash flows that must be forgone as the resutl of invetment decision
what are externalities
the consequences that result forman investrment that may benefit or harm unrelated thrid parties
what is the initial after-tax cash flow (CF0)
the total cash outlay required to initiate an investment project, including the change in net working capital and associated opportunity costs
what is captial cost (C0)
all costs incurrred to make an investment operational, such as macinery installation expenses, land-clearing csots, and so; these can be deprecaited for tax purposes
what is expected annual after-tax cash flows (CFt)
the cash flows that are estimated to occur as a result of the investment decision, comprising the assocaited expected incremental increase in after-tax opearting incoem and any incremental tax savings (or additional taxes paid) that result from the initial investment outlay
what is the equation for NPV
NPV = PV(annual CFs) + PV(ECFn) - CF0
the basic cash flow pattern has what
an initial investment and t = 0,
an annual stream of after-tax cash flow benefits at each time period
and, at the end of its useful life, ending cash flow benefits after-tax
what is the equation for the initial after -tax cash flow (CF0)
add equation 14-1
what does this equation represent?
what is the equaiton for ending (or Terminal) Afterr-tax cas flow (ECFn)
14-4 add equation
if there are tax issues, the ECF must be modified. what is the equation to adjust for any taxes payable on the salveage value due to captial gains or recapture of depreciation
add equation 14-3
once you have estimated the cash flows what should happen
1. determine their after-tax vaues
2. determine their peresent value
3. sum the present value to determine the NPV
the equation is:
NPV = PV (Annual CFs) + PV (ECFn) - CF0
what are the two approaches to determining cash flows?
1. before-tax opearting income (before depreciation) - CCA = taxable income - taxes payable = after-tax income + CCA (Non-cash expense) = Net cash flow
2. Before-tax operating income (beforedepreciation) - taxes payable on operating income = after-tax opearting income + CCA tax savings = Net Cash flow
the tax sheild benefit form CCA is equal to what
the corproate tax rate multipled by the CCA amount
T x CCA
assuming the firm wil have taxable opearting income in the future, we can predict the maximium amount of CCA the firm can claim from the year of acquisition throuh to infinity what are some of the rules that apply to the CCA
1. the half- year rule is in effectin the first year
2. we assume we calim the maximum CCA in each subsequent year
3. we forecast the tax sheild benefit as: T x CCA
4. tax sheild benfits will be perpetual stream of cash flows that are growing at a constant negative compund growth rate d which is the CCA rate
CCA provides large tax shield benefits when
in the early years of an asset's useful life (it is an accelerated depreciaiton method)
what happens with residual values in the asset pool for CCA
residual values remain in the asset pool long after the asset was acquired, which means a firm will never fully recoup the cost of the asset.
as the firm's asset base ages, cash flwos generated from CCA will not enable the firm to replace the orignal asset
the difference between the salvage value and the purchase price is what
the capital gain
what part of the capital gain is subject to tax
50% of the realized capital gain is subject to tax at the corporate tax rate
the PV of after-tax operating cash flows
plus the PV of the CCA tax sheild benefits
Plus the PV of the ending cash flow (which is the salvage value plus the recovery fo the net working capital investment)
minus taxes payable on the realized capital gain and /or the recapture of depreciation
minus the initial investmnet in the asset (both the purcahse price and the investment in net working capital)
why do you stress test NPV models
to determine the senseitivity of hte decsion to input variables is an important part of risk assessment
what are the two common approaches for stress testing NPV
1. senszitivity analysis
2. Scenario analysis
what is sensitivity analysis
is an examiniation of how an investment's NPV changes as the value of one input at a time is changed
what is scenario analysis
is an examination of how an invesetment's NPV changes in response to varying scenarios in terms of one or more estimates, such as sales or costs
what is ending (or terminal) after-tax cash flow (ECFn)
the total cash flow that is expected to be generated in the terminal year of a project, aside fomr that year's expected after-tax cash flow; thje estiamted salvage value of the asset