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Question 1

Capital budgeting - Buy vs Lease

Finance

Answer 1

• calculate NPV of each option and compare to determine which option is cheapest
• NPV of buy option - consider :
• > cost of asset
• > PV of tax shield
• > maintenance costs
• NPV of lease option - consider:
• > PV of after tax lease payments
• other factors to consider :
• > impact on covenants
• > cash flows (leasing lessens the current cash burden)
• > leasing may be easier to come by if company has trouble obtaining financing
• > purchasing the asset might provide more flexibility ( ownership of assets )
• > leasing might insulate company from severe declines in asset value
• > possible tax advantages ( no capital leases for tax purposes - cRA sees all leases the same so cash payments would be deductible, however no CCA)

Question 2

Financing options - Debt vs Equity

Answer 2

Debt financing options :

• > loan - consider loan term, and security/collateral required
• > lease
• > government assistance

Equity financing options :

• > angel investors - friends, family looking for ROI; passive investors
• > venture capitalists - professional investment funds, looking for superior returns (> 30%); active participants in mgt with a clear exit strategy
• > private equity - tends to participate later in business lifecycle, hence lower risk
• > public markets

Question 3

Incremental Cash Flows

What is incremental cash flows?
What to costs are considered when determining incremental cash flows from a new project?

Answer 3

Incremental CF comprise the ADDITIONAL cash flows from taking on a new project, incorporating the tax-affected initial outlay, annual revenues and expenses, and terminal value (or cost) associated with the project, in accordance with the scale and timing of the project

When determining incremental cash flows from a new project, consider:
-> sunk costs - these are the INITIAL outlays that cannot be recovered even if a project is accepted. As such, these costs will not AFFECT FUTURE CASH FLOWS of the project and are NOT CONSIDERED incremental

• > Opportunity Costs - These represent any potential loss of current cash flows due to accepting a new project and are considered incremental
• > Cannibalization - This is the OPP COST where a new project takes sales away from an existing product
• > Working Capital Changes - These represent changes in receivables, payables and inventory due to accepting a new project and are therefore considered incremental

Question 4

NPV vs IRR

Answer 4

• The NPV rule states that you invest in any project which has a positive NPV when its cash flows are discounted at the opportunity cost of capital, also known as the discount rate (usually the cost of raising the capital to fund the project)
• the IRR rule states that you invest in any project offering a rate of return which exceeds the opportunity cost of capital
• a project’s rate of return is calculated as the discount rate at which the NPV of the project = 0
  Therefore, the NPV and IRR rules should give the same accept/reject answer about a project, in most circumstances
• a project’s cash flows should include incremental elements only (I.e. additional sales, associated expenses, lost margin on cannibalization, investment & associated tax-shield etc., but no financing elements, as discounting of the cash flows already addresses financing

Question 5

Discounted vs. Undiscounted C/F

Answer 5

• Incremental C/F (excluding financing elements) should be discounted to recognize the time value of money for the purposes of making a decision regarding accepting or rejecting a project
• incremental C/F (including financing elements) should be analyzed year over year, without discounting, to determine if a certain cash position would be met by a certain time

Question 6

Payback period

Answer 6

• Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment
• in general, investments with lower payback period are preferred
• to determine, calculate the cumulative net cash flow for each period and then use the following formula for payback period:

Payback period - A + B / C, where:

A - is the last period with the negative cumulative cash flow;
B - is the absolute value of cumulative cash flow at end of the period A; and
C - is the total cash flow during the period after A

Question 7

Contribution Margin

Answer 7

• CM is the determination of how much variable profit is available to cover fixed costs and generate a profit
• in general, the higher CM, the better
• To determine CM, calculate the variable revenues per unit (hour, day, year, quantity) offset by the variable costs of the Sam
  • CM is A - B where:
    A = total variable revenue per unit; B = total variable expense per unit

Question 8

Break-even analysis

Answer 8

• BE is the determination of sales volumes necessary to generate a zero-profit
• BE can be expressed in # of units, total revenues or % of expected revenues
• To determine, calculate the fixed costs per period, and divide them by the CM to determine the necessary sales volumes to generate zero-profit

   - BE is A/B where
        A = total Fixed costs; B = CM per unit