Search
Create
Log in
Sign up
Log in
Sign up
Get ahead with a $300 test prep scholarship
| Enter to win by Tuesday 9/24
Learn more
CFA2 Corporate Finance
STUDY
Flashcards
Learn
Write
Spell
Test
PLAY
Match
Gravity
Terms in this set (16)
28. Capital Budgeting
Testable material => Core curriculum
Capital Budgeting Principles
-Decisions based on incremental A-T (after taxes) cash flows,
not accounting income
*Sunk costs: Not incremental =>can not get back
*Externalities :Incremental
-Important point: Financing costs reflected in required return
*Treat projects as if 'all equity' financed
* Note: this is different from real estate
Incremental Expansion project CF: (3 stages)
1) Initial Investment outlay
2) After-tax operating cash flow (CF)
3) Terminal Year After-tax Non-operating Cash Flow (TNOCF)
1) Initial Investment Outlay (Outlay)
= FCInv + NWCInv
FCInv = Cost of fixed capital
NWCInv = delta non-cash C.A. - delta non-debt C.L.
Cash ouflow if > 0
Cash inflow if < 0
2) After-tax operating cash flow (CF)
= (S − C − D)(1 − T) + D
= (S − C)(1 − T) + DT
S: sales;
C: Cash operating expenses;
T:Marginal tax rate;
D: Depreciation expenses
3) Terminal Year After-tax
Non-operating Cash Flow (TNOCF)
TNOCF = Sal_t + NWCInv − T(Sal_t − B_t)
Sal_t: Pre-tax cash proceeds from sale of fixed capital
NWCInv: Recovery of NWCInv (Do not forget!!!!)
B_t: Book value of fixed capital
T: Marginal tax rate
Replacement Project CF
Same as those of expansion project EXCEPT:
*Sale of old: Reduce the initial outlay by the ater-tax proceed the sale (t=0):
Outlay = FCInv + NWCInv - Sale - T(Sale -BV)
*Depreciation: Use only the difference between old and new depreciation
*Consider only incremental cash flows from new project
Effects of Inflation
-Nominal vs. real CFs: Must match CF with correct discount rate
-Higher than expected inflation:
1) Reduces value of depreciation tax shield
2)Decreases value of fixed payments to bondholders
3)Different impact on revenues vs. costs
Projects with Unequal lLives: 2 Methods:
1) Least Common Multiple of Lives Method
2) Equivalent Annual Annuity (EAA)
1) Least Common Multiple of Lives Method
-Extends the lives of the projects so that the lives divide equally into the chosen time horizon.
-Assumed that the projects are repeated
=>Decision:Select the higher (equal-life) NPV
2) Equivalent Annual Annuity (EAA)
-Calculate Annuity payment equivalent for each NPV
=>Decision:Select the project with the higher EAA
Capital rationing
-Allocate fixed capital among to maximize shareholder wealth.
- If +NPV project > capital
=>Choose the combination with highest total NPV.
Risk analysis techniques
1-Sensitivity analysis
2-Scenario analysis
3-Simulation analysis
1-Sensitivity analysis
*Involves varying an independent variable to see how much the dependent variable changes, all other things held constant.
-Begin with the base case
-Change A SINGLE input variable
-NOTE the change in NPV
-Change other input variables
*Point: Projects with NPVs more sensitive to changes in input variables are riskier
2-Scenario analysis
*considers the sensitivity of the dependent variable to simultaneous changes in all of the independent variables.
-Uses best-case, worst-case, and most-likely case scenarios
-Calculate the mean and std of NPV
3-Simulation analysis (Monte Carlo)
*uses repeated random draws from the assumed probability distributions of each input variable to generate a simulated distribution of NPV.
Monte Carlo simulation:
-Forecast probability dist. for key inputs
-Do random draw, caluclate NPV, repeat
-Generate probability distribution of NPV
;