Topic 2 - capital budgeting

Question 1

What is Capital Budgeting?

Answer 1

Process used to analyze alternate investments and decide which ones to accept
To calculate NPV of project, estimate future cash flows & required return (“discount rate”)

Question 2

What do you need to forecast cash flows?

Answer 2

incremental earnings

Question 3

What are Incremental Earnings?

Answer 3

The amount by which the firm’s earnings are expected to change as a result of the investment decision

Question 4

What does Incremental cash flows - After tax cash flows include?

Answer 4

opportunity costs

Include externalities

Question 5

What does Incremental cash flows - After tax cash flows does NOT includes?

Answer 5

sunk costs
allocated overhead
financing costs (e.g., interest expense)

Question 6

What is a Marginal Corporate Tax Rate?

Answer 6

The tax rate on the marginal or incremental dollar of pre-tax income.
Income Tax = EBIT (rev-cost-dep) x corp tax rate

Question 7

What do you get for a negative tax?

Answer 7

tax credit

Question 8

What is the Unlevered Net Income Calculation = NOPAT = incremental earnings after taxes?

Answer 8

=EBIT x (1 - corp tax rate)

Question 9

HOw do you determine a free cash flow and NWC

Answer 9

The incremental effect of a project on a firm’s available cash is its free cash flow

Question 10

How do you calculate free cash flow from earnings

Answer 10

Capital Expenditures and Depreciation

Question 11

what are Capital Expenditures?

Answer 11

the actual cash outflows when an asset is purchased. These cash outflows are included in calculating free cash flow.

Question 12

is Depreciation an expense and what is it?

Answer 12

is a non-cash expense. The free cash flow estimate is adjusted for this non-cash expense.

Question 13

How to calculate the free cash flow from earnings with NWC?

Answer 13

NWC = current assets - current liabilities

= cash + inventory = receivables - payables

Question 14

will most projects require an investment in net working capital?

Answer 14

Yes

Question 15

What is trade credit

Answer 15

the difference between receivables and payables

Question 16

How do you calculate an increase in NWC?

Answer 16

Delta NWC 1 = NWC1 - NWC t-1

Question 17

when looking at NWC, why do we ignore notes payable when looking at NWC?

Answer 17

because we are only looking at the financing effects

Question 18

Why do we need to consider changes in Net Working Capital (ΔNWC) separately?

Answer 18

Need ΔNWC because of differences between accounting & finance; look at Cost of Goods Sold (“CGS”) calculation

Question 19

Does GAAP require that sales be recored on the income statement when it’s made or when cash received?

Answer 19

It requires it when income statements are made, not when it’s received

Question 20

Does GAAP require that we record cost of goods sold ?

Answer 20

When the corresponding sales are made, regardless of whether we have actually paid our suppliers yet

Question 21

Why do we need to consider changes in Net working Capital (NWC) separately?

Answer 21

In accounting,
Beginning inventory + cost of goods purchased = cost of goods available for sale
1) subtract ending inventory to get = Cost of goods sold
2) In accounting report CoGS as expense only when we make sales, under matching principle
3). BUT in finance, we are concerned with when we make the cash outlay, not with GAAP.
Cash outlay when purchased beginning inventory (before sale) and at end of machine life,
1)Can use beginning inventory => hence CGS overstates cash outflow in last year of project;
2)Hence we “recover” change in NWC at the end of the project.

Question 22

Free cash flow formula

Answer 22

FCF = (rev - costs- dep ) * (1 - corp tax rate) + dep - capEX - change in NWC

Question 23

What is tax depreciation shield?

Answer 23

= (corp tax * dep)

Question 24

What are the two methods of depreciation adjustments for free cash flows?

Answer 24

Straight line and Accelerated depreciation