Week 10 Capital Budgeting II

Question 1

What is capital budgeting?

Answer 1

The process used to analyse alternate projects and decide which one(s) to accept or reject

Question 2

What is the goal of capital budgeting?

Answer 2

Determine the effect of the accept/reject decision on the firm’s cash flows

Question 3

What is the usual process of capital budgeting?

Answer 3

Evaluate the NPV of these cash flows to assess

Question 4

How do you treat the cash flows in calculating NPVs?

Answer 4

1. Use cash flows, not accounting income
2. Ignore sunk costs
3. Include OC
4. Include side effects
5. Include working capital
6. Include taxation impacts
7. Exclude financing costs
8. Take care with inflation

Question 5

What are free cash flows?

Answer 5

The incremental effect of a project on a firm’s available cash

Question 6

Why do we not use accounting income when calculating NPV?

Answer 6

It is based on arbitrary revenue and expense recognition rules used by accountants

Question 7

What is an example of something included in accounting income?

Answer 7

Capital expenditure - arbitrarily expensed (depreciated) over the life of the project in the calculation of accounting income

Question 8

How do you calculate Free Cash Flow (FCF)?

Answer 8

Operating cash flow - Capital expenditures - Increase in working capital requirements

Question 9

How do you calculate operating cash flow?

Answer 9

Revenues - Cash expenses - taxes OR EBDIT - Taxes

Question 10

How do you calculate working capital requirements?

Answer 10

Current year’s working capital requirements - previous year’s working capital requirement

Question 11

What are cash expenses?

Answer 11

Accounting costs that result in cash outflows: eg. Cost of Goods Sold (COGS), general and administrative expenses

Question 12

What are some examples of cash expenses?

Answer 12

Cost of goods sold (COGS), general and administrative expenses

Question 13

Is depreciation expense a cash expense?

Answer 13

No

Question 14

How do you calculate taxes?

Answer 14

Taxes = earnings before interest and taxes (EBIT) * taxation

Question 15

What are sunk costs?

Answer 15

Any costs that will be incurred regardless of whether you accept or reject the project

Question 16

Why are sunk costs irrelevant to decision making?

Answer 16

They are not incremental cash outflows. Even if they have been incurred as a direct result of evaluating the project because they have been (or will be) incurred regardless of whether or not the project goes ahead.

Question 17

What are overhead costs?

Answer 17

They are a type of sunk cost - they are costs which are incurred by the firm but cannot be attributed to a specific project

Question 18

What is an opportunity cost?

Answer 18

Opportunity costs occur when a resource is used in a project that could otherwise be put to some productive use.

Question 19

How do we include opportunity costs in calculating NPV?

Answer 19

The dollar value of the best alternative use must be included as a cash outflow in calculating the NPV because the opportunity cost is ‘consumed’ in undertaking the project

Question 20

What is a side effect?

Answer 20

A positive or negative cash flow that relates to other aspects of a company’s business as a result of implementing the project.

Question 21

What are some types of side effects?

Answer 21

Positive and negative incidental effects of externalities

Question 22

What is working capital?

Answer 22

Funds set aside to ensure that the company has sufficient cash flows to maintain operations whilst undertaking the project

Question 23

How do you calculate net working capital?

Answer 23

change in net working capital = change in current assets - change in current liabilities

Question 24

Why does working capital have to be included in cash flow calculations?

Answer 24

It has an opportunity cost

Question 25

How is working capital included in NPV calculations?

Answer 25

Most projets will require an investment in net working capital at the onsent that should be recognised as a cash outflow in cash flow forecasts. When the project comes to an end, one can usually recover all or some of this investment, which results in a cash inflow

Question 26

What is taxation?

Answer 26

Taxation represents a cash outflow and needs to be included in calculations

Question 27

What role does taxation play in calculating cash flows?

Answer 27

Cash flows should be estimated on an after-tax basis. After tax cash flows must be discounted using an after-tax required rate of return.

Question 28

How can tax influence projects?

Answer 28

a. corporate income tax b. depreciation --> tax deduction = tax shield c. Liquidation or salvage value

Question 29

What is depreciation?

Answer 29

Depreciation is deducted when calculating the taxable income but is not an actual cash flow

Question 30

What is the effect of depreciation?

Answer 30

The only effect of depreciation is to reduce the tax payable. Therefore it acts as a 'tax shield'.

Question 31

What are some other tax considerations?

Answer 31

1. Assets that are no longer needed can be sold 2. Need to adjust project's free cash flows to account for after-tax cash flow that would result from liquidation of asset

Question 32

What is taxable capital gain?

Answer 32

If an asset is sold for a price higher than its current book value, then the difference is treated as a taxable cpaital gain. This is a reflection of the fact that the aset was over depreciated in the first place.

Question 33

What is capital loss?

Answer 33

If an asset is sold for a price lower than its current book value, then the difference is treated as a capital loss. This creates a deduction for taxable income that can be used elsewhere in the company.

Question 34

How do you calculate capital gain?

Answer 34

Capital gain = sale price - book value

Question 35

How do you calculate book value?

Answer 35

Book value = original purchase price - accumulated depreciation

Question 36

How do you calculate tax on asset sale?

Answer 36

Tax on asset sale = -(sale price - book value) x tax rate

Question 37

What are financing costs?

Answer 37

All cash flows associated with financing a project are ignored

Question 38

How does a company determine how to finance a project?

Answer 38

The companhy must assess if the project is value increasing before determining how to finance it

Question 39

What is the effect of inflation on cash flows?

Answer 39

Inflation can reduce the purchasing power of future cash flows.

Question 40

How do you apply inflation to calculation questions?

Answer 40

Be consistent in how inflation is treated. Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows

Question 41

What is Fisher's effect?

Answer 41

(1+rn) = (1+rr)*(1+p) where: rn = nominal rate of return rr = real rate of return p = inflation rate