Making Capital Investment Decisions Flashcards
(29 cards)
What is capital budgeting?
- the process of analyzing potential long-term investments (fixed assets)
- long term decisions involve large expenditure and risk
- very important to firm’s future
What is the capital budgeting process?
- Proposal generation
- Review / analysis and decision making
* Estimate CFs (inflows & outflows).
* Assess riskiness of CFs.
* Determine the appropriate cost of capital.
* Find NPV and/or IRR.
* Accept if NPV > 0 and/or IRR > WACC. - Implementation
- Follow up
What are the considerations for the relevant cash flows?
- is it a cash item?
- will the item change if the new project is undertaken?
- use only cash flows (nominal vs real)
- only after-tax cash flows are relevant (taxes are cash outflow items)
Types of cashflow:
- Cash flows from investment (CFI)
- Cash flows from operations (CFO)
- Opportunity Costs Sunk Costs
- Working capital
- Externalities/Cannibalization
- past research and development expenditures
- unavoidable competitive pressures
- allocated costs
what is opportunity cost?
(e.g. revenues that could be earned otherwise - use of equipment that could other wise be sold)
what is sunk costs?
(costs already incurred - use of idle equipment already purchased)
what is working capital
Extra cash commitments due to implementation of project, recovered
at the end of project’s life
* Examples: cash required for inventory, extra cash commitments
* NWC = Cash + Inventory + Receivables - Payables
what is externalities/cannibalization
Cash flows affecting existing projects due to implementation of new
project
* Example: loss of sales on current products due to a new project
Why should we ignore financing costs?
Financing costs should be excluded when evaluating a
project’s cash flows.
1. Both interest expense from debt financing and dividend payments
to equity investors should be excluded.
2. Financing costs are captured in the process of discounting future
cash flows
what are allocated costs?
Companies often allocate costs such as rent, power, water, head office
costs, travel and other overhead costs to their divisions
what are the 3 periodic cashflow types?
Initial outlay, Ongoing cashflow, terminal cashflow
what costs make up the initial outlay:
- purchase equipment
- initial development costs (installing items, buying land etc)
- increasing in net working capital (increase in inventory, raw materials etc)
what costs make up the ongoing cashflow
- incremental revenue
- incremental costs
- taxes
- changes in net working capital (change in inventory, raw materials, accounts receivable and payable)
what costs make up terminal cashflow
- sale of equipment (net of any taxes)
- shutdown costs
- decrease in net working capital (decrease in raw materials, inventory etc
What are the 2 types of projects?
- expansion projects
- replacement project
difference between expansion and replacement project
Expansion Projects
* Consider only changes to operating cash flows
* Assume the risk is similar to the current
project/business
Replacement Projects
* Compare current cash flows with those from the replacement project
What is depreciation
depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It reflects the gradual decrease in an asset’s value due to wear and tear, obsolescence, or other factors.
what is the important thing to remember about depreciation
BUT generates cash flow in the form of tax shield (i.e. The
Depreciation Tax Shield
= Depreciation x Tc
methods of calculating depreciation
Straight line (prime cost) method
* Reducing balance (diminishing value) method (not examinable)
* Accelerated depreciation – MACRS (not examinable)
how do you calculate capital gain
Capital Gain = Sale Price – Book Value
how do you calculate book value
Book Value = Purchase Price – Accumulated depreciation
how do you calculate the after tax cahsflow from asset sale
After tax cash flow from asset sale = Sale Price – (Tc x Capital Gains)
what are the considerations for a replacement project?
– Initial cost
– year economic life
– Salvage value in 5 years
– Incremental cost savings per year
– Annual depreciation
Required return = 10%
Tax rate = 30%
- do sales revenue remain constant?
how is project life determined?
by the time of asset disposal
