Week 3 Flashcards
(35 cards)
What is capital budgeting?
Capital budgeting is the process that companies use for decision making on capital projects, that is, investments in non-current assets. Capital budgeting involves evaluating the size of future cash flows, the timing of future cash flows, and the riskiness of future cash flows.
What are the types of capital projects?
The types of capital projects are: replacement projects, expansion projects, new products and services, regulatory, safety and environmental projects, and more
What are the main potential sources of cash flows?
Cash flows come from sales and other revenues, the cost of sales and expenses, depreciation, working capital, and taxes.
How do revenues affect cash flows?
Revenue contributes to cash flows positively by a factor of (1-tax rate).
How does depreciation affect cash flows?
Depreciation is not a real cash flow, however it provides a tax shelter and tax savings, this means depreciation affects cash flows positively by reducing taxable income. The depreciation tax shield equals the depreciation expense * the tax rate, and adds that much to the cash flow.
What are the two methods of calculating depreciation?
The prime cost (straight line) method, and the reducing balance(diminishing value) method.
How does the prime cost method of calculating depreciation work?
The prime cost(straight line) method of computing depreciaiton applies a constant rate to the asset’s initial cost to identify allowable deduction each year, this means depreciation = the depreciation rate * the initial book value.
How does the reducing balance (diminishing value) method of calculating depreciation work?
The reducing balance (diminishing value) method applies a constant rate to the assets beginning of year book value to identify the allowable deduction each year, this means depreciation is a variable amount which declines over time. In this case, depreciation at time t = the depreciation rate * the book value at time t-1.
What is net working capital? What is it used for? What occurs at the end of the project?
The net working capital is the difference between current assets and current liabilities. It is the cash employed to run day-to-day operations of a firm, it is not consumed but rather employed for a period of time. An increase in working capital during a period means more cash is employed, which is a cash outflow. A decrease in working capital during a period means less cash is employed, this is a cash inflow.
The working capital is normally assumed to be recovered at the end of the project (a cash inflow).
What are the major impacts of taxation on cash flows?
Taxation has three major impacts:
- Income tax represents a cash outflow.
- Tax shield - depreciation provides a tax deduction which results in a tax saving.
- Capital gains tax lowers the net profit received from the sale of an asset and may result in a tax saving when a loss is made from the sale of an asset.
What are the two possibilities of tax with relation to the sale of an asset?
Generally the sale of an asset generates a gain/profit or a loss (if sold for less than book value), a gain is subject to tax, while a loss will result in a tax deduction.
What are the three potential approaches for calculating cash flows?
The three potential approaches for calculating operating cash flows are top-down, bottom up, or tax shield.
How do we use the top-down approach for calculating operating cash flows?
The top-down approach for calculating operating cash flow is: revenue - cash costs -taxes. Taxes is (revenue - costs - depreciation)*tax rate.
How do we use the bottom-up approach to calculate operating cash flows?
The bottom-up approach is revenue - expenses - depreciation*(1-tax rate) + depreciation.
What are some important things to remember with regards to discounting, and the estimation of cash flows?
When discounting, only cash flow is relevant, we should always estimate the cash flows on an incremental basis, and be consistent in our treatment of inflation.
Should we include sunk costs?
We should ignore sunk costs as they are cash outflows that were incurred in the past and are no longer relevant to influencing whether a prospective project should be undertaken.
What are opportunity costs with relations to projects? What about side effects?
We need to account for opportunity costs, and side effects in our project analysis. opportunity costs are our lost revenues due to alternative uses. We should take these away from our cash flows.
Side effects can have a positive (synergy), in which case a new project increases cash flows of existing projects, or be negative (erosion), in which case a new project decreases cash flows of existing projects.
Should we include existing costs in our project analysis?
We shouldn’t allocate existing overheads (fixed costs) we should only assign any change in fixed costs to a proposed project.
Do we need to include changes in net working capital in our analysis? How can they occur?
We must remember to include any change in net working capital, this could occur due to extra stocks of raw materials and work in progress to support the manufacturing operations, or additional stocks of finished goods and debtors to support the selling function.
Should we include interest costs in our project analysis?
Interest/financing costs should not be included as an explicit cash flow because interest costs are included in the required rate of return (discount rate / cost of capital) to evaluate the project, if the project’s NPV is positive the cash flows from the investment will cover interest costs.
What is important with regard to real and nominal interest rates and calculating cash flows?
Nominal cash flows should be discounted at the nominal rate, real cash flows must be discounted at the real rate.
What equation relates the nominal interest rate and real interest rate?
(1+nominal rate_ = (1+ Real rate)*(1+expected inflation).
What are the three major periods in terms of cash flows?
In a typical project the initial outlay involves things like purchasing equipment, initial development costs, and an increase in net working capital. It will have ongoing cash flows coming in the form of incremental revenues, incremental costs, taxes, and changes in net working capital. Finally it has terminal cash flows, these consist of sale of equipment, shutdown costs, and a decrease in net working capital.
How do we calculate the initial cash outflow?
The initial cash outflow is the initial net cash investment, to calculate the initial cash outflow:
Cost of new assets + capitalized expenditures +(-) the increase(decrease) in net working capital - net proceeds from sale of asset(s) if replacement +(-) tax(savings) due to sale of old asset(s) if replacement.
