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BU 393 > Chp 10: capital budgeting: estimating CF > Flashcards

Chp 10: capital budgeting: estimating CF Flashcards

1
Q

how do we estimate CF in capital budgeting?

A

We compute incremental cash flows from projects and compute the NPV of the incremental cash flows

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2
Q

define incremental cash flow

A

cash flows (costs and revenues) that change because of the new production line

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3
Q

what happens if incremental CFs have positive NPV

A

the value of the company is greater if it adopts the project and the change in the company’s value is equal to the NPV of the incremental cash flows

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4
Q

3 ways capital equipment affects NPV

A

1) cash outflow at time 0
2) depreciation tax shield in each year
3) creates positive cash flow due to net salvage (bring to Present)

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5
Q

what does UCC include?

A

purchase price and installation

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6
Q

what do we need to remember when rent is per month for opportunity cost

A

make sure to multiply by 12.

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7
Q

when can’t we use EAA?

A

when cash flows change for a project after replacement project

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8
Q

what is CCA called?

A

capital cost allowance

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9
Q

what is CCA’s system?

A

CRA’s system for calculating depreciation expenses for tax purposes

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10
Q

CCA method

A

declining balance depreciation method and assigns assets to property classes where each property class has a different depreciation rate

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11
Q

CCA asset class 1

A

buildings = 4% depreciation rate

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12
Q

CCA asset class 8

A

furniture, appliance, tools = 20%

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13
Q

CCA asset class 10

A

vehicles = 30%

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14
Q

CCA asset class 38

A

power operating moveable equipment = 30%

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15
Q

CCA asset class 43

A

machinery and equipment = 30%

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16
Q

CCA asset class 52

A

computer hardware = 100%

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17
Q

formula for annual depreciation expense t

A

depreciation rate * UCC t - 1

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18
Q

define UCC

A

undepreciated capital cost at the end of the previous year (aka book value of the asset)

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19
Q

formula for UCC

A

capital cost - accumulated depreciation

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20
Q

define accumulated depreciation

A

sum of all depreciation expenses claimed for an asset

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21
Q

what is UCC in year 0

A

capital cost of the asset

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22
Q

define capital cost of asset

A

original cost of asset + shipping costs and any other costs associated with installing the asset

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23
Q

what does CCA assume and what does this mean

A

CCA system assumes that all assets are purchased in the middle of the year so in the first year of an asset’s life, a company can only claim a half-year of depreciation (divide depreciation rate in 2)

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24
Q

what 2 things creates a tax shield

A

depreciation and interest expense

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25
Q

why does depreciation and interest expense create a tax shield

A

they are tax deductible so it reduces taxes by an amount equal to the product of the expense and the corporate tax rate

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26
Q

what is the tax shield

A

The difference between if depreciation is and is not tax deductible

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27
Q

formula for operating cash flow

A

EBITDA - depreciation + depreciation since depreciation is a non-cash charge

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28
Q

formula for tax rate

A

taxes paid / earnings before taxes

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29
Q

what happens when an asset is sold?

A

proceeds from the sale are a positive cash flow

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30
Q

define salvage value and aka

A

resale value of an asset at the end of a project. Also called scrap value.

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31
Q

*** are proceeds from selling asset taxable?

A

no **

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32
Q

what happens if asset is sold for more than purchase price?

A

difference is taxable capital gain

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33
Q

what happens if salvage < UCC

A

then a residual amount is left in the pool and that residual generates a perpetual series of tax shields

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34
Q

formula for PV tax shield

A

tax rate * depreciation rate * (UCC (t) - Salvage) / (cost of capital + depreciation rate)

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35
Q

numerator of PV tax shield

A

tax shield in the year t +1 associated with the residual

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36
Q

why do we have negative growth rate for PV tax shield (+ depreciation rate)

A

because tax shield declines over time

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37
Q

what happens when salvage > UCC

A

When salvage > UCC, then the whole expression is negative and it takes away some UCC from other assets in the company. This reduces the tax shield that those assets would have generated.

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38
Q

formula for net salvage

A

Net salvage = salvage + PV tax shields

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39
Q

what happens if net salvage is less than salvage

A

PV of tax shields is negative so UCC is less than salvage value

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40
Q

formula for depreciation tax shield

A

depreciation expense * tax rate

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41
Q

formula for PV depreciation tax shield

A

depreciation tax shield / (1+WACC)^t

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42
Q

If net salvage is less than the salvage value of the​ asset, then we know that the undepreciated cost of the asset is the same as/greater than/less than the salvage value of the asset.

A

less than

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43
Q

2 ways projects are classified

A

expansion or replacement projects

44
Q

define replacement projects

A

old asset is replaced by new asset

45
Q

define expansion project

A

new project. There are no old costs and revenues to complicate analysis

46
Q

what do almost all projects require?

A

ongoing capital investments throughout their operating lives

47
Q

what does our analysis of projects include?

A

initial cash flow, annual operating CF, terminal CF

48
Q

formula for initial cash flow

A

= - initial purchase price of new asset - installation/shipping cost of new asset - increase in net working capital (all of these components are subtracted because they represent cash outflows)

49
Q

why does increase in NWC represent cash outflow?

A

means the company is buying more assets

50
Q

formula for NWC

A

(current assets - cash) - (current liabilities - debt)

51
Q

when might new asset result in reduction of NWC

A

if it allows for increased efficiency in inventory management (less assets)

52
Q

2 things we assume for NWC

A

Realistically, net working capital is usually tied to sales and fluctuates with sales. Assume NWC is liquidated in the terminal year of the project which generates a positive cash flow.

53
Q

define operating cash flow

A

revenues less costs and taxes. Also equal to net income plus interest and depreciation

54
Q

when is project only accepted?

A

Only if PV cash inflows > PV of investment (NPV > 0)

55
Q

what is NOPAT - formula and what it stands for

A

EBIT(1-t) is NOPAT - net operating profit after tax

56
Q

what is EBITDA also called

A

gross profit

57
Q

what do we do if depreciation is not tax deductible?

A

completely ignore it from OCF calculation

58
Q

define terminal cash flows

A

cash flows spent (or received) in the final year of a project

59
Q

formula for terminal cash flow

A

OCF + net salvage value + decrease in net working capital

60
Q

what time period is terminal cash flow

A

last year of the OCF

61
Q

True or​ False? If working capital increases in the terminal​ year, then that increase will reduce terminal year cash flows.

A

true

62
Q

incremental cash flows associated with replacement formula

A

Cash flows with replacement - cash flows with keeping old equipment

63
Q

what time is date of replacement

A

time 0

64
Q

replacement: initial cash flow

A
  • purchase price of new asset + salvage value of old asset - increase in NWC
65
Q

CCA implications for when asset is replaced

A

When an asset is replaced, the CCA system adds the cost of the new machine to the asset class and deducts the salvage value of the old machine. This always increases the UCC balance in the class so there are no tax implications associated with purchase or sale at time of replacement. The tax implication is associated with CCA (depreciation)

66
Q

replacement: incremental OCF

A

OCF after replacement - OCF with old asset = change in EBIT(1-t) + change in depreciation

67
Q

replacement: what changes for pooled UCC asset class

A

For depreciation, salvage value of old asset is removed from pooled UCC of asset class and the capital cost of new asset is added

68
Q

replacement: incremental capital cost

A

cost of new machine - salvage value of old machine

69
Q

replacement: what is UCC at time 0

A

incremental capital cost

70
Q

replacement: what is incremental depreciation expense

A

Incremental depreciation expense is the declining balance depreciation expense associated with the incremental capital cost

71
Q

replacement: does half year rule apply?

A

yes

72
Q

replacement: formula for incremental salvage

A

salvage value of new machine - salvage value of old had it been kept in service

73
Q

replacement: formula for net incremental salvage

A

incremental salvage + PV incremental tax shields

74
Q

what do we remember when OCF and terminal CF when calculating NPV?

A

do not include OCF in terminal year

75
Q

6 rules to follow when estimating CF

A

1) aggressively seek and include indirect costs
2) disregard sunk cost
3) include opportunity cost
4) consider externalities
5) adjust for taxes
6) ignore financing costs

76
Q

define indirect costs and give example

A

cost to a business that is not directly related to making the product/service; doesn’t affect the per unit cost of production. Example: insurance

77
Q

define sunk costs

A

irreversible past costs

78
Q

define opportunity cost

A

full cost of a choice, value of the best forsaken alternative

79
Q

formula for opportunity cost

A

direct cost + indirect cost

80
Q

define indirect cost with respect to opportunity cost and give 2 examples

A

value of assets used but not paid for

time, land

81
Q

define externalities

A

a cost (or benefit) that accrues to a 3rd person who is not a direct party to a transaction, a side effect

82
Q

what are project externalities usually?

A

negative

83
Q

do we include effect of sales on other companies in externalities?

A

no

84
Q

what does ignoring financing costs mean and why do we do it?

A

Do not include interest cost in estimating cash flows. The financing decision is separate from capital budgeting decision.

85
Q

what would happen if we were to include interest costs?

A

The NPV and IRR includes cost of funds by using discount rate that reflects required return. If we were to include interest expense, we would be double charging the project for financing.

86
Q

why may a larger project have largest NPV

A

because it consumes company resources for a long time

87
Q

which may have larger NPV: series of shorter projects or one long term project

A

series of shorter projects

88
Q

what do both methods for comparing projects with unequal lives assume?

A

they both assume that when the short term project concludes another similar project will be available

89
Q

2 methods for projects with unequal lives

A

1) replacement chain approach

2) equivalent annual annuity method

90
Q

define replacement chain approach

A

involves repeating each project until a common length is achieved and then comparing the net present values of the 2 streams of cash flows

91
Q

replacement chain approach: if project lasts for 5 years, when do add another initial investment?

A

at time 5

92
Q

what does EAA avoid?

A

Avoids problem where lengths are not multiples of each other

93
Q

define EAA

A

essentially the NPV per year. It is an annual dollar amount (for each year of a project’s life) that has a PV equal to the project’s NPV

94
Q

what does EAA assume

A

Assumes both projects can be repeated forever

95
Q

what are cash flows converted into in EAA and why

A

Cash flows converted into annuities which can be compared

96
Q

rationale for EAA

A

firm is going concern in that similar substitute projects will be available

97
Q

what happens if unusual projects are being evaluated with different lives?

A

neither approach is appropriate

98
Q

steps for EAA

A

1) compute NPV for each project
2) find annuity payments that have the same PV as the NPV and the same number of periods as the project. (PV should be negative when solving for PMT)
3) EAA is the PMT
4) higher EAA is one to choose because it generates more NPV per year

99
Q

3 problems with both EAA and replacement chain projects

A

1) Replacement similar jobs may not be available
2) Due to inflation, subsequent costs may be higher than initially projected
3) All errors with estimating cash flows are compounded when we assume CF repeat

100
Q

why do we incorporate sensitivity analysis in NPV analysis?

A

To incorporate uncertainty into NPV analysis

101
Q

define sensitivity analysis

A

series of analyses that reflect the effects of different assumptions

102
Q

what does sensitivity analysis tell us

A

It tells use how sensitive the results are to changes in the estimates

103
Q

steps for sensitivity analysis

A

1) prepare complete cash flow estimation schedule
2) compute NPV of cash flows
3) vary each uncertain estimate over its reasonable range and record resulting NPV from each change
4) graph results from 3
5) scenario analysis. Prepare additional evaluations by changing more than one input

104
Q

define scenario analysis

A

group of assumptions are changed simultaneously to determine impact on project’s profitability. Assumptions are connected by a theme, typically boom and bust case (everything right and everything wrong)

105
Q

sensitivity analysis graph using sales

A

NPV y axis, sales x axis, graphing NPV, the more steep the line, the more sensitive the NPV is to sales estimates

106
Q

do we treat OC as pre-tax?

A

yes

BU 393 (3 decks)

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