Lecture 11 Capital Budgeting II

Finance

What are the learning outcomes for Topic Eleven: Capital Budgeting?

Evaluate after-tax free cash flows for NPV calculations and understand and calculate the Annual Annuity Equivalent (AAE).

What types of projects are considered in capital budgeting?

Replacement projects, expansion projects, new product or market development, mandatory projects, and others.

Why should cash flows be used instead of accounting income in NPV calculations?

NPV depends on the project’s free cash flows, which reflect the actual cash increase or decrease due to the project, rather than accounting income based on arbitrary recognition rules.

What are relevant cash flows in NPV analysis?

Incremental cash flows that will occur only if the project is accepted, reflecting the expected change in the firm’s earnings.

What is a sunk cost?

A cost that has been incurred and cannot be recovered, thus it should not be included in incremental earnings analysis.

What should be done with the feasibility study cost in capital budgeting?

The feasibility study cost is considered a sunk cost and should not be included in the incremental earnings analysis.

What is an opportunity cost in capital budgeting?

The dollar value of the best alternative use of a resource that is sacrificed when making an investment decision.

How should project externalities be treated in NPV calculations?

Side effects that result from implementing the project, such as cannibalization of sales from existing products, must be included in the analysis.

What are the key components of free cash flow (FCF)?

Free Cash Flow = Operating Cash Flow - Capital Expenditures - Change in Working Capital Requirements.

What tax aspects need to be considered in capital budgeting?

Taxation represents a cash outflow and must be estimated on an after-tax basis; taxation influences project cash flows via corporate income tax, depreciation, and salvage value.

What is the significance of depreciation in cash flow analysis?

Depreciation is a non-cash expense that reduces taxable income and acts as a tax shield.

How do we define net working capital (NWC)?

NWC is the difference between a company's current assets and current liabilities.

What is the formula for calculating a change in net working capital (NWC)?

∆NWC = NWC(t) - NWC(t-1).

What does an increase in NWC indicate for cash flows?

An increase in NWC means more cash is tied up in receivables and inventory, which reduces available cash flows.

What factors should be considered when comparing projects with different lives?

NPV must be standardized over an identical period to compare mutually exclusive investments, or use the Equivalent Annual Annuity (EAA) approach.

What is the Equivalent Annual Annuity (EAA) and why is it useful?

EAA is used to compare projects with different lifespans by converting their NPVs into an annual amount.

In capital budgeting, should interest expense be included in project evaluations?

Interest expense is typically not included as capital budgeting focuses on the project's operating performance independently of its financing.

What is the importance of considering inflation in cash flow projections?

Inflation can diminish the purchasing power of future cash flows, thus affecting project profitability and must be consistently accounted for.

What happens to the cash flow when the salvage value of an asset is considered?

The salvage value generates a cash inflow at the end of the project and can result in a taxable gain or loss.

What is the impact of cannibalization on NPV calculations?

Cannibalization must be included in the NPV analysis as it represents a loss of revenue from existing products due to the introduction of new products.