Upgrade to remove ads
CFA II: SS8 - Capital Budgeting
Terms in this set (24)
Broad Categories of Capital Budgeting Projects
1. Replacement Projects to maintain the business - normally made without detailed analysis.
2. Replacement Projects for cost reduction - Is obsolete but still useable equipment worth replacing? fairly detailed.
3. Expansion Projects - Involve complex decision making process. Very detailed.
4. New Product or Market Development - Large amount of uncertainty so very detailed.
5. Mandatory Projects - may be required by gov. agency. Normally safety or environmental concerns.
6. Other projects - Often difficult to analyze.
Key Principles of Capital Budgeting
1. Decisions are based on cash flows, not accounting income. I.e. we only care about incremental Cf. Do not consider sunk costs. Consider externalities like cannibalization.
2. Cash Flows are based on opportunity costs.
3. Timing of cash flows is important.
4. Cash Flows are analyzed on an after-tax basis.
5. Financing costs are reflected in the project's required rate of return.
Modified Accelerated Cost Recovery System (MACRS)
MACRS is the choice of depreciation method most often used in the U.S. for tax purposes.
Under MACRS assets are classified into 3-, 5-, 7- or 10 year classes and each year's depreciation is determined by the applicable recovery percentage.
The half year convention under MACRS assumes that the asset is placed in service in the middle of the first year. The effect is to extend the recovery period of a 3yr asset to four calendar years and a 5 to 6.
The depreciable basis is equal to the purchase price plus any shipping or handling and installation costs. The basis is not adjusted for salvage value.
Capital Project Incremental Cash Flows
1. Initial Investment Outlay
2. Operating CF over the project's life
3. Terminal-year cash flow
1. Initial Investment Outlay
The up front costs associated with the project. Price, including shipping and installation (FCInv) and Investment and net working capital (NWCInv).
outlay = FCInv + NWCInv
NWCInv must be included in the capital budgeting decision. Whenever a firm undertakes a new operation additional inventories are usually needed to support increased sales. This leads to increase A/R, A/P and accruals.
NWCInv is defined as the difference between the changes in non-cash current assets and liabilities.
NWCInv = ∆non-cash CA - ∆non-cash CL = ∆NWC
If NWCInv is positive additional financing is required and we get a cash outflow because cash must be used to fund the net inv. in CA.
2. After Tax Operating Cash Flows
These are the incremental cash flows over the capital asset's economic life. defined as:
CF = (Sales - cash costs - dep. exp.)(1-t) + dep. exp.
= (Sales - Cash Costs)(1-t) + (t x Dep. Exp)
Although depreciation is a non cash operating expense it is an important part of determining operating cash flow because it reduces taxes paid by the firm. You can account for it using either formula above. Higher dep exp will result in higher cash flows those first few years.
3. Terminal Year After Tax Non Operating CF
At the end of the asset's life there are certain cash inflows that occur:
TNOCF = SalT + NWCInv - T (SalT- BT)
SalT = pretax cash proceeds from sale of fixed capital
BT = Book value of the fixed capital sold.
Replacement Project Analysis
Occurs when a firm must decide whether to replace an existing asset with a newer or better asset. Two key differences here, we have to...
1. Reflect the sale of the old asset in the initial outlay:
outlay = FCInv + NWCInv - Sal₀ + T (Sal₀ - B₀)
2. Calculate the incremental op. cash flows as the cash flows from the new asset minus the cash flows from the old asset.
∆CF = (∆S - ∆C)(1 - T) + ∆DT
Effects of Inflation on Capital Budgeting
Inflation is a complication that must be considered as part of the capital budgeting process:
- Nominal v Real Cash Flows - Either is fine but make sure you are discounting with the corresponding rate.
- ∆'s in Inflation Affect Project Profitability
- Inflation reduces the tax savings from depreciation
- Inflation decreases the value of payments to bondholders.
- Inflation may affect revenues and costs differently.
ME Projects w/ Different Lives
If ME projects have different lives, and the projects are expected to be replaced indefinitely as they wear out, an adjustment needs to be made in the decision-making process. Two procedures:
1. Least Common Multiple of Lives Approach - Ex. a 3yr project v. a 6yr project. Find the least common multiple (6) and assume no changes in CF (multiple machine purchases).
2. Equivalent Annual Annuity (EAA) Approach - Finds the sequence of annual payments that is equal to the projects NPV. Resulting calc is an annual payment that allows for an apples to apples comparison of projects with different lives. You just calc the PMT using the FV and PV N and WACC for I. Whichever PMT is greater is your choice.
This is the allocation of a fixed amount of capital among the set of available projects that will maximize shareholder wealth. If you have less capital than profitable projects, you choose the combination that maximizes shareholder wealth.
Hard capital rationing occurs when the funds allocated to managers under the capital budget cannot be increased. Soft Capital Rationing occurs when managers are allowed to increase their allocated capital budget if they can justify to senior management that the add'l funds will create shareholder value.
Involves changing an input (independent) variable to see how sensitive the dependent variable is to the input variable.
Is a risk analysis technique that considers both the sensitivity of some key output variable (e.g. NPV) to changes in a key input variable and the likely probability distribution of these variables. (Worst Case, Best Case, Base Case etc etc).
Simulation Analysis (Monte Carlo Simulation)
Results in a probability distribution of project NPV outcomes, rather than just a limited number of outcomes as with sensitivity or scenario analysis.
Step 1: Assume a specific prob distribution for each input variable. i.e. sales are normally distributed with a mean of 100,000 and a std. dev of 15,000.
Step 2: Simulate a random draw from the assumed distribution of each input variable.
Step 3: Given each of the inputs, calculate project NPV.
Step 4: Repeat Step 2 and 3 10,000 times
Step 5: Calculate the mean NPV, the std. dev of the NPV and the correlation of NPV with each input var.
Step 6: Graph the resulting 10,000 NPV outcomes as a probability distribution.
Rproject = Rf + βproject [E(Rmkt) - Rf]
Rf = risk-free rate
βproject = project Beta
E(Rmkt) - Rf = market risk premium
Using a project's Beta to determine discount rates is important when the risk of a project is different from the risk of the overall company.
Allow managers to make future decisions that change the value of capital budgeting decisions made today. Real options are similar to financial call and put options in that they give the option holder the rise, but not the obligation, to make a decision. Real options however are based on real assets rather than financial assets and are contingent on future events. They offer managers flexibility that can improve the NPV estimates for individual projects.
Types of Real Options
1. Timing Options - allow a co. to delay making an investment with the hope of having better info in the future.
2. Abandonment Options - Similar to put. Allow managers to abandon a project if the PV of incremental Cf from exiting exceed the cf from continuing.
3. Expansion Options - similar to call. Allow co. to make additional investments in a project if it creates value.
4. Flexibility Options
- Price Setting - allow co. to ∆ product price.
- Production Flex - overtime, diff inputs.
5. Fundamental Options - Are projects that are options themselves because payoffs depend on the price of an underlying asset.
Profitability of an Investment w/ Real Options
Real Options simply put add value to an investment, even if it is hard to measure monetarily. In order to quantify calc the NPV without the option and then add the estimated value of the real option:
overall NPV = Project NPV (based on DCF) - option cost + option value
Project Economic Income
Econ Income is equal to the after-tax cash flow plus the change in the investment's market value.
economic income = cash flow + (beg. MV - end MV)
Project Accounting Income
Is the reported net income on a company's financial statements that results from an investment in a project. It will differ from economic income because:
- Accounting depreciation is based on the original cost (not MV) of the investment.
- Financing costs are considered as a separate line item and subtracted out to arrive at NI.
Is a measure of profit in excess of the dollar cost of capital invested in a project.
EP = NOPAT - $WACC
NOPAT = Net operating profit after tax = EBIT (1-t)
$WACC = dollar cost of capital = WACC x capital
capital = dollar amount invested.
NPV based on Econ Profit
NPV = MVA (Market Value Added = ∑ (EPt / (1+WACC)^t)
Note that the MVA will always equal the traditional NPV approach.
residual income = net income - equity charge
RIt = NIt -reBt-1
RIt = residual income in period t
NIt = net income in period t
re = required return on equity
Bt-1 = beg. of period book value of equity
NPV = ∑ (RIt / (1 + re)^t)
Claims Valuation Approach
Divides operating cash flows based on the claims of the debt and equity holders that provide capital to the company. These D&E cash flows are valued separately and then added together to determine the value of the company.
YOU MIGHT ALSO LIKE...
Finance 303 - Final
CFA 3 R43 GIPS
CH 21 Practice
OTHER SETS BY THIS CREATOR
Series 24 - Chapter 1
CFA II: SS18 - Portfolio Concepts
CFA II: SS5 - Long Lived Assets
CFA II: SS4 - Regulation and Anti-Trust
THIS SET IS OFTEN IN FOLDERS WITH...
LIFO and FIFO comparison (Inflation & Stable/Incre…
Capitalizing vs. Expensing
CFA L2 Cash flows, models, formulas, etc