Chapter 8 – Fundamentals of Capital Budgeting

200 flashcards covering key concepts, definitions, formulas, and applications from Chapter 8: Fundamentals of Capital Budgeting.

What is capital budgeting?

The process of analyzing investment opportunities and deciding which ones to accept.

Define capital budget.

A list of all projects that a company plans to undertake during the next period.

Which decision rule is used to evaluate capital budgeting decisions?

The NPV rule.

When should a project be accepted under the NPV rule?

When the project has a positive NPV.

What are incremental earnings?

The amount by which a project is expected to change the firm’s earnings.

Should incremental earnings include sunk costs?

No, sunk costs are excluded.

Should incremental earnings include interest expenses?

No, interest and other financing-related expenses are excluded.

What is a project externality?

A cash flow that occurs when a project affects other areas of the company’s business.

Define opportunity cost in capital budgeting.

The value an asset would provide in its best alternative use.

Define a sunk cost.

An unrecoverable cost that has already been incurred.

What tax rate is used to estimate taxes in capital budgeting?

The firm’s marginal tax rate.

What is unlevered net income?

EBIT × (1 − tc) = (Revenues − Costs − Depreciation) × (1 − tc).

Give the formula for unlevered net income.

Unlevered Net Income = (Revenues − Costs − Depreciation) × (1 − tc).

Why is interest ignored when computing unlevered net income?

Because the project is evaluated separately from its financing decision.

Free cash flow formula (basic)

FCF = (Revenues − Costs − Depreciation) × (1 − tc) + Depreciation − CapEx − ΔNWC.

What is free cash flow?

Cash generated by the project that is available to all investors after operating expenses and investments.

Is depreciation a cash expense?

No, it is a non-cash expense.

How is depreciation treated when computing FCF?

It is added back to after-tax earnings.

How are capital expenditures treated in FCF?

They are deducted (cash outflow).

How are increases in net working capital treated in FCF?

They are deducted because they use cash.

Define net working capital (NWC).

Cash + Inventory + Receivables − Payables.

What is the discount rate for a project called?

Its cost of capital.

When choosing between mutually exclusive projects, which project is chosen?

The project with the highest NPV.

Should sunk costs be included in incremental earnings?

No, they must be excluded.

What are overhead expenses?

Costs that are not directly attributable to a single project but support the firm’s overall operations.

Define cannibalization in capital budgeting.

Reduction in sales of a firm’s existing products due to the introduction of a new product.

What is straight-line depreciation?

Depreciation method that allocates equal amounts each year.

Give the straight-line depreciation formula.

Annual Depreciation = (Cost − Salvage Value) ÷ Useful Life.

What is MACRS depreciation?

Modified Accelerated Cost Recovery System; an accelerated depreciation method allowed by the IRS.

Define bonus depreciation.

Tax rule allowing expensing of a large portion (often 100%) of an asset’s cost immediately.

What is a depreciation tax shield?

Tax savings from the deductibility of depreciation expenses.

What type of tax rate should be used for the tax shield?

The marginal corporate tax rate.

How do you calculate the depreciation tax shield?

Depreciation × Marginal Tax Rate.

Define terminal (continuation) value.

The present value of a project’s future cash flows beyond the forecast horizon.

What happens if an asset is sold for more than its book value?

Tax is due on the difference (a taxable gain).

Define break-even analysis.

Computes the level of a parameter that makes the project’s NPV equal zero.

Define sensitivity analysis.

Shows how NPV varies as individual assumptions change.

Define scenario analysis.

Analyzes the effect of changing multiple parameters simultaneously.

What is trade credit?

Short-term credit extended by suppliers for inventory purchases.

Explain EBIT break-even point.

The sales level at which EBIT equals zero.

Formula for EBIT break-even sales volume.

EBIT = 0 ⇒ Sales = (Fixed Costs + Depreciation) ÷ (Price − Variable Cost per Unit).

What is a deferred tax asset?

Asset recorded when taxes payable exceed tax expense; arises from temporary differences.

Define net operating loss (NOL).

Negative taxable income that can be carried forward to offset future taxable income.

What are tax carryforwards?

Tax rules allowing NOLs to offset taxable income in future years.

Define scenario (best, base, worst) cases.

Different sets of assumptions representing optimistic, most likely, and pessimistic outcomes.

What is overhead allocation?

Assigning a portion of overhead costs to a project.

When are financing costs considered in capital budgeting?

When determining the discount rate, not in the cash flows.

What is an Excel data table used for in sensitivity analysis?

To compute NPV for many values of a key input automatically.

What is a spider plot?

Graph showing NPV sensitivity to changes in individual inputs.

Define real option.

The right, but not the obligation, to undertake certain business initiatives, such as deferring, expanding, or abandoning a project.

What is the salvage value?

The expected after-tax cash inflow from selling an asset at project end.

How do you compute after-tax salvage value?

Sale Price − (Tax Rate × (Sale Price − Book Value)).

Define capital expenditures (CapEx).

Cash spent on acquiring or upgrading physical assets.

Why is NWC recovered at the end of a project?

Because inventories are sold and receivables collected, freeing cash.

Should inflation be included in cash flow forecasts?

Yes, cash flows and discount rate must be expressed consistently in nominal or real terms.

What is the nominal discount rate?

Rate that includes expected inflation.

What is the real discount rate?

Rate that excludes expected inflation.

Fisher equation (approximate).

1 + nominal rate ≈ (1 + real rate)(1 + inflation).

How does leverage affect WACC?

Debt can lower WACC due to tax deductibility of interest, up to a point.

Do capital budgeting cash flows include financing flows?

No, they focus on operating and investment flows.

What is bonus depreciation’s effect on FCF?

Increases early depreciation, increasing tax shields and early FCF.

Should existing land’s current market value be in project cash flows?

Yes, as an opportunity cost if the land will be used.

Is demolition cost of an old building part of project cost?

Yes, if required to undertake the project (incremental cash flow).

Are research expenses incurred last year included?

No, they are sunk costs and excluded.

Why use after-tax cash flows?

Because taxes are real cash outflows that affect value.

Define EBITDA.

Earnings before interest, taxes, depreciation, and amortization.

When is EBITDA used?

As a proxy for operating cash flow before CapEx and working capital changes.

Define EBIT.

Earnings before interest and taxes; operating income.

Is straight-line or accelerated depreciation better for NPV?

Accelerated depreciation (e.g., MACRS) gives higher NPV due to earlier tax shields.

Define accrual accounting.

Recognizes revenues and expenses when earned/incurred, not when cash changes hands.

Why adjust net income to free cash flow?

Because accounting earnings include non-cash items and exclude capital investments.

Example of non-cash expense.

Depreciation or amortization.

What happens to FCF if inventories rise?

FCF decreases due to cash tied up in working capital.

Is a deferred tax asset a cash flow?

No, it impacts taxes in future periods, not immediate cash.

Define MACRS class life.

IRS-designated recovery period for accelerated depreciation of assets.

What is EBIT(1−tc)?

Unlevered net income; after-tax operating income excluding financing.

Define project cannibalization.

Negative impact on existing product sales due to a new project.

How is cannibalization treated in analysis?

As a negative incremental revenue (cost) of the new project.

Define sunk cost fallacy.

The mistake of considering sunk costs when making decisions.

Why ignore sunk costs?

They cannot be recovered and are not affected by the decision.

Give an example of a sunk cost.

Past R&D spending.

Define initial investment (year 0 cash flow).

Net cash outflow at project start, including CapEx and NWC investment.

What is the payback period?

Time until cumulative project cash flows turn positive.

Is payback used in NPV?

No, it is an alternative, less accurate decision criterion.

Define IRR.

Discount rate that makes NPV equal zero.

Why can IRR be misleading?

Multiple IRRs, unconventional cash flows, and scale differences can distort comparisons.

Define profitability index.

PV of future cash flows ÷ Initial investment.

When is PI useful?

For ranking projects under capital rationing.

What is Sunk Cost Bias?

Tendency to continue an unprofitable project due to past investment.

Define escalation of commitment.

Increasing commitment to a failing course of action to justify prior decisions.

What is scenario planning?

Comprehensive analysis combining different macroeconomic conditions and project assumptions.

How does depreciation affect taxes?

Reduces taxable income, creating a tax shield.

Define liquidation value.

Net cash flow from selling assets at project end.

Why subtract ΔNWC in FCF?

Because increases in NWC represent cash uses not captured in net income.

Define capital rationing.

When a firm limits its capital expenditures due to budget constraints.

What is break-even revenue?

Sales needed for NPV to equal zero.

Define salvage tax effect.

Tax on difference between sale price and book value when disposing an asset.

What is the average corporate tax rate?

Total tax paid ÷ Taxable income.

What is the marginal tax rate?

Tax rate on the next dollar of income.

Which tax rate is used in capital budgeting?

Marginal tax rate.