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1

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.
 

 

 

2

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

3

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:
 

4

What is marginal or Incremental cash flows

the additional cash flows that result from cpatial budgeting decisions, generated by new projects

5

what are sunk costs

costs that have already been incurrred, cannot be recovered, and should not influencence current capital budgeting decisions

6

what is opportunity cost

cash flows that must be forgone as the resutl of invetment decision

7

what are externalities

the consequences that result forman investrment that may benefit or harm unrelated thrid parties

8

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

9

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

10

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

11

what is the equation for NPV

NPV = PV(annual CFs) + PV(ECFn) - CF0

12

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

13

what is the equation for the initial after -tax cash flow (CF0)

add  equation 14-1

14

what does this equation represent?

14-2

add

add

15

what is the equaiton for ending (or Terminal) Afterr-tax cas flow (ECFn)

14-4 add equation

16

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

17

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

18

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

19

the tax sheild benefit form CCA is equal to what

the corproate tax rate multipled by the CCA amount

T x CCA

20

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

21

CCA provides large tax shield benefits when

in the early years of an asset's useful life (it is an accelerated depreciaiton method)

22

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

23

the difference between the salvage value and the purchase price is what

the capital gain

24

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

25

NPV =

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)

26

why do you stress test NPV models

to determine the senseitivity of hte decsion to input variables is an important part of risk assessment

27

what are the two common approaches for stress testing NPV

1.  senszitivity analysis

2.  Scenario analysis

28

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

29

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

30

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