Valuation Class 10-27

What is Capital Budgeting (and its formal time-horizon threshold)?

The decision-making process of evaluating long-term investments and large expenditures to obtain the best return on investment, specifically when expected cash inflows occur over a period of MORE THAN ONE YEAR. It also includes disinvestment (selling off an undertaking or part of it).

How does Capital Budgeting Include Disinvestment (Divestiture)?

Capital budgeting is a two-way street: in addition to evaluating new investments, it explicitly includes the decision to sell off an entire undertaking or a division/asset when it no longer generates adequate economic returns.

What are the 3 Primary Objectives of Capital Budgeting (Slide 5)?

(1) Selecting profitable projects that add net economic value, (2) Capital expenditure control to prevent cost overruns and undisciplined spending, and (3) Finding the right sources for funds to match long-term assets with appropriate financing.

What are Capital Expenditures ("CapEx") and their typical budget horizon (Slide 8)?

Funds used by a firm to acquire, upgrade, and maintain long-term fixed assets (property, plant, equipment, or technology) to increase the scope of operations or add future economic benefit. CapEx budgets typically cover 5 to 10 years (refined annually or more often) and reflect a company's "five-year plan."

How does Session 10 shift the analytical focus from earlier sessions in FIN 6352 (Slide 7)?

Earlier sessions examined financial valuation and modeling for COMPLETE corporate entities; Session 10 narrows the focus to PROJECT-LEVEL and ASSET-LEVEL capital budgeting and CapEx modeling/decisions.

What are the 4 Strategic Types of Capital Budgeting Projects (Slide 7)?

(1) Expansion (increasing capacity of existing operations), (2) Replacement (substituting worn-out/obsolete equipment), (3) Diversification (entering new markets or product lines), and (4) Strategic Investment (long-term capabilities, R&D, or competitive moats).

What are the 5 Physical/Intangible Categories of Capital Expenditures (Slides 9-13)?

(1) Building, Land & Property, (2) Computer Hardware, (3) Upgrade Machinery, (4) Software Infrastructure, and (5) Vehicles.

What are the real-world corporate CapEx cases highlighted on Slide 6?

Tesla's $3.6B Nevada Gigafactory expansion (Semi & 4680 batteries), Eli Lilly's $450M Research Triangle Park pharmaceutical plant expansion, Nestle Health Science's $43M Wisconsin factory expansion, and LG Energy Solution's Michigan battery plant expansion (while GM joint-venture plans stalled).

How does Alfred D. Chandler Jr.'s "Strategy and Structure" (1962) connect to Capital Budgeting?

Chandler showed that the modern multi-divisional industrial enterprise is defined by how headquarters allocates long-term resources (facilities, machinery, and capital) across divisions over 5-to-10-year horizons; capital budgeting is the quantitative grammar of that strategic allocation.

How does Michael C. Jensen's Free Cash Flow Agency Theory (1986) explain the "Corporate Jet" CapEx prompt on Slide 7?

Jensen demonstrated that managers with substantial free cash flow face a temptation to spend on perquisites (like corporate jets) or low-return empire-building projects rather than returning cash to shareholders—illustrating why Objective #2 (Capital Expenditure Control) is essential.

What are the 6 Capital Allocation Principles (Slide 14)?

(1) Decisions are based on cash flows (not accounting income), (2) Measure incremental cash flows (with vs. without the project), (3) Timing of cash flows is crucial, (4) Cash flows are analyzed on an after-tax basis, (5) Cash flows used are real cash (reflecting non-cash charges properly), and (6) Financing costs are ignored in project cash flows.

Capital Allocation Principle #1 & #5: Why are decisions based on Real Cash Flows rather than Accounting/Accrual Income?

Accounting net income or operating income subtracts non-cash charges like depreciation. Because a firm cannot spend accounting profit, analysts use real cash flows and add back non-cash charges after accounting for their tax impact.

Capital Allocation Principle #2: What is an Incremental Cash Flow, and how does it treat Sunk Costs?

Incremental cash flow is the marginal difference ("the delta") in the firm's cash flows WITH the investment compared to WITHOUT it. It strictly ignores sunk costs (past outlays that cannot be recovered regardless of today's decision).

Capital Allocation Principle #3 & #4: Why do Timing and Taxes matter in Capital Allocation?

Timing is crucial because of the time value of money, duration, and volatility (a dollar in Year 1 is worth more than a dollar in Year 5). After-tax analysis is required because taxes are a real cash outflow and depreciation/loss tax shields directly alter net cash returns.

Capital Allocation Principle #6: Why are Financing Costs (such as interest expense) IGNORED when calculating project cash flows?

To avoid DOUBLE-COUNTING. Financing costs are already embedded in the required rate of return (discount rate / WACC) used to discount the cash flows. Subtracting interest from cash flows AND discounting by WACC would penalize the project twice.

What are the 3 Kinds of Capital Budgeting Decisions (Slides 15-16)?

(1) Accept-Reject Decisions, (2) Mutually Exclusive Choice Decisions, and (3) Capital Rationing Decisions.

What is an Accept-Reject Decision (Slide 15)?

The fundamental standalone decision of whether to invest in a proposed project or not: if expected returns meet or exceed the hurdle criteria, the firm accepts (invests in) the project; if not, it rejects the project.

What is a Mutually Exclusive Choice Decision (Slide 15)?

A decision among competing investment alternatives where ONLY ONE may (or needs to) be selected—for example, choosing the best among three brands of the same type of machine when the firm only needs one. Accepting one automatically eliminates the others.

What is a Capital Rationing Decision, and why is it harder to resolve (Slide 16)?

A situation where a firm has MORE acceptable investments than it has funds to finance them. It is more difficult to resolve because management must select the optimal GROUP (bundle) of assets under a budget constraint rather than evaluating a single asset in isolation.

How does Barry M. Staw's "Escalation of Commitment" research relate to Sunk Costs (Slide 41)?

Staw showed that decision-makers often continue pouring additional capital into failing projects to justify prior sunk investments ("throwing good money after bad"), violating Capital Allocation Principle #2 (measuring only forward-looking incremental cash flows).

How do Capital Expenditures (CapEx) differ from Operating Expenses (OpEx) in purpose and tax treatment (Slide 17)?

OpEx are shorter-term expenses required for ongoing day-to-day operations (rent, wages, routine repairs) and are FULLY DEDUCTED for taxes in the same year they occur. CapEx acquires or upgrades long-term assets and is capitalized on the balance sheet and depreciated over multiple years.

What are the 3 Accounting Criteria that classify an expense as CapEx rather than OpEx (Slide 17)?

An expense is CapEx when it is: (1) a newly purchased capital asset, OR (2) an investment with a useful life of more than one year, OR (3) an expenditure that improves or extends the useful life of an existing capital asset.

The Repair Trap (Slide 17): Is a repair considered CapEx or OpEx?

If the expense merely MAINTAINS the asset at its current working condition (a routine repair), it is OpEx and deducted fully in the current year. If it is a major overhaul that IMPROVES or extends the useful life/capacity of the asset, it is CapEx.

What is the Direct Method Formula for Net CapEx, and why is it rarely used by external analysts (Slide 18)?

Net CapEx = Amount spent on Asset #1 + Amount spent on Asset #2 + Amount spent on Asset #3 - Value received for Assets sold. External analysts rarely use it because companies do not usually disclose asset-by-asset purchase and sale receipts in public financial statements.

What is the Indirect Method Formula for Net CapEx (Slides 18-20)?

Net CapEx = (Ending PP&E - Beginning PP&E) + Current Period Depreciation Expense. (Note: Beginning PP&E of the current year equals Ending PP&E of the previous year; using Gross PP&E, it equals Change in Gross PP&E + Change in Accumulated Depreciation.)

Why do we ADD Depreciation Expense in the Indirect CapEx Formula (Slides 19-20)?

Because Net PP&E on the balance sheet is reduced each year by depreciation. To end the year with a higher Net PP&E balance, the firm had to spend enough CapEx to offset 100% of that year's depreciation charge PLUS the net increase in PP&E.

Calculation Practice (Slide 20): If Beginning PP&E = $42,300, Ending PP&E = $47,200, and Depreciation Expense = $12,300, what is Net CapEx?

Net Increase in PP&E = $47,200 - $42,300 = $4,900. Net CapEx = $4,900 + $12,300 = $17,200.

Calculation Practice (Slide 21 CFI Model): In 2027, Ending PP&E = $39,000, Prior Year (2026) Ending PP&E = $38,500, and 2027 Depreciation & Amortization = $15,900. What is 2027 CapEx?

Net Increase in PP&E = $39,000 - $38,500 = $500. 2027 CapEx = $500 + $15,900 = $16,400.

Slide 19 Discussion Question: What real-world corporate actions cause the simple Indirect CapEx equation (Change in Net PP&E + Depreciation) to break down?

(1) Mergers & Acquisitions (M&A) or Divestitures (adding or removing large blocks of PP&E at once), (2) Asset Impairment write-downs, (3) Foreign Exchange (FX) translation adjustments on international PP&E, and (4) Asset sales/disposals that remove accumulated depreciation from the balance sheet.

What is the difference between Maintenance CapEx and Growth CapEx (Slide 22)?

Maintenance CapEx is spending required to replace worn-out equipment and sustain existing operations at current revenue levels (modeled as a steady % of revenue). Growth CapEx is discretionary spending on new capacity to drive future revenue expansion (typically higher in high-growth years and declining as the firm matures).

In the Slide 22 Wall Street Prep Model, what happens to Growth CapEx and the Depreciation-to-CapEx ratio as the firm matures from Year 1 to Year 5?

As revenue growth slows from 10.0% to 2.0%, Growth CapEx drops from 3.0% to 0.5% of revenue, and Depreciation % of Total CapEx rises from 66.7% to 100.0% in Year 5 ($2.0M Depreciation / $2.0M CapEx), causing Net PP&E to plateau at $26.9M.

Where do you find Capital Expenditures directly on a company's financial statements (Slide 23)?

On the Statement of Cash Flows under the "Cash Flows from Investing Activities" section (often listed as "Capital Expenditures" or "Additions to Property, Plant, and Equipment").

What is the answer to the Slide 35 "W" Clue ("What are each of these tables above called? Clue: The word begins with a W")?

A Waterfall schedule (specifically a Depreciation Waterfall or PP&E Roll-Forward Waterfall table), which tracks how each annual vintage/layer of new CapEx adds its own multi-year depreciation stream down the diagonal rows.

What is the Capital Acquisition Ratio, and how is it expressed (Slides 25, 29)?

Capital Acquisition Ratio = Operating Cash Flow (OCF) / Capital Expenditures. It is expressed as a multiple (such as 1.0x) and measures a company's capacity to fund its CapEx requirements internally using cash generated from core business operations.

How do you interpret a Capital Acquisition Ratio (Cash Flow to CapEx Ratio) GREATER than 1.0x vs. LESS than 1.0x (Slide 26)?

> 1.0x: Healthy—operations generate excess discretionary cash flow that can fund all CapEx and be reinvested in growth. < 1.0x: Warning sign—OCF is insufficient to cover CapEx; urgent cost-cutting is needed and CapEx should be restricted to maintenance CapEx only (no growth CapEx) to avoid depleting cash reserves, illiquidity, missed interest payments, and debt default.

What is the CapEx to Operating Cash Flow Ratio, and how does it relate to the Capital Acquisition Ratio (Slides 27-29)?

CapEx to Cash Flow Ratio (%) = Capital Expenditures / Operating Cash Flow (OCF), expressed as a percentage (%). It is the mathematical reciprocal (inverse) of the Capital Acquisition Ratio and measures the percentage of OCF allocated toward purchasing long-term fixed assets.

Slide 27 Discussion Question: What does it mean if the CapEx to Operating Cash Flow Ratio is GREATER than 100%?

A CapEx-to-OCF ratio > 100% is the exact mirror of a Capital Acquisition Ratio < 1.0x: the company is spending more than 100% of its internal operating cash flow on CapEx, meaning it must dip into existing cash reserves, borrow debt, or issue equity to finance its capital spending.

What are the 3 key analytical uses of the CapEx to Operating Cash Flow Ratio (Slide 28)?

(1) Evaluates a company's focus on growth, (2) Shows how much of a company's CapEx is funded in cash from operations, and (3) Useful for assessing financial risk.

What is Scenario Analysis in financial modeling, and what is the difference between the "simple" and "more robust" approaches (Slide 30)?

Scenario Analysis estimates the expected value of a firm or project after changing key input factors when favorable or unfavorable events could occur. The "simple" approach is Best-Case / Worst-Case analysis; the "more robust" approach is Multiple-Scenario analysis focused on the inputs that have the greatest effect on value.

What are the 3 Main Problems/Limitations of Multiple-Scenario Analysis (Slide 30)?

(1) Requires a high level of skill, carrying a risk of "garbage in, garbage out" (GIGO), (2) Cannot model every scenario (especially difficult when risk is continuous rather than discrete), and (3) Vulnerable to unforeseen outcomes and double-counting risk.

What are the 4 Benefits of a Well-Done Simulation in Capital Budgeting (Slide 31)?

(1) Future planning (predictive visibility into expected returns and risks), (2) Proactive management (aggressively preventive action against worst-case triggers), (3) Avoiding risk and failure (weighing best and worst probabilities for informed decisions), and (4) Projecting cash flows or losses (quantifying potential gains and losses).

What is Decision Tree Analysis, and what kind of risk is it specifically designed for (Slide 32)?

Decision Tree Analysis is a visual flowchart outlining potential outcomes, costs, and consequences of a complex decision based on quantitative inputs. Unlike continuous-risk models, decision trees are specifically designed for SUBSEQUENT (sequential) and DISCRETE risks to find the optimal course of action at each phase and an Expected Value (EV) today.

What are the 5 Standard Symbols used in a Decision Tree (Slide 33)?

(1) Square = Decision Node (indicates a decision to be made), (2) Circle = Event Node (shows multiple uncertain outcomes with probabilities), (3) Diagonal branching lines = Alternative Branches (possible outcomes or actions), (4) Branch with double slash marks = Rejected Alternative (choice not selected), and (5) Triangle = End Node (indicates a final outcome/payoff).

How do you calculate the Expected Value (EV) of each branch in the Slide 34 Decision Tree (Game vs. Productivity App vs. Revamp)?

EV = Sum of (Outcome Payoff x Probability) - Initial Cost. (1) Build Game: ($200k x 0.38) + ($100k x 0.62) - $75k = $63k. (2) Build Productivity App: ($150k x 0.59) + ($80k x 0.41) - $50k = $71.3k [Optimal Choice]. (3) Revamp Existing App: ($120k x 0.55) + ($60k x 0.45) - $30k = $63k.

How does Decision Tree Analysis connect to Dixit and Pindyck's "Investment under Uncertainty" (Real Options Theory, 1994)?

Dixit and Pindyck showed that when capital investments are irreversible and uncertain, the managerial flexibility to stage investments sequentially, wait for information, or abandon a project (mapped via decision nodes in a decision tree) carries quantifiable value similar to a financial option.

What are the 3 Common Tax Depreciation Methods compared on Slide 36 (for a $10,000 asset, 5-year life, $0 salvage, 25% tax rate)?

(1) Straight-Line (SLN): equal $2,000/year over Years 1-5. (2) Double Declining Balance (DDB): accelerated method using 2 x ((Asset Cost - Accumulated Depreciation) / Life), or 40%/year of remaining book value. (3) MACRS (Modified Accelerated Cost Recovery System): IRS statutory table incorporating a half-year convention that spreads a 5-year asset's depreciation across 6 calendar years (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%).

On Slide 36, why do DDB and 5-year MACRS show depreciation expense in Year 6 for a 5-year asset, and what are the Year 4 Ending Tax Bases across SLN, DDB, and MACRS?

MACRS uses a half-year convention (treating the asset as placed in service mid-year in Year 1 and disposing/finishing mid-year in Year 6), and DDB plugs the remaining $778 book value in Year 6. At the end of Year 4 (on a $10,000 asset), Accumulated Depreciation and Ending Tax Basis are: SLN = $8,000 Acc. Dep. / $2,000 Tax Basis; DDB = $8,704 Acc. Dep. / $1,296 Tax Basis; MACRS = $8,272 Acc. Dep. / $1,728 Tax Basis.

What is the 2-Step Method for calculating Cash Flow After Taxes (Salvage Value After Sale and Tax) when selling an asset (Slide 37)?

Step 1 (Calculate Tax): Find Tax Basis = Original Cost - Accumulated Depreciation; then find Pretax Gain/(Loss) = Sales Price - Tax Basis - Broker Fee; then multiply Pretax Gain/(Loss) by the Tax Rate (25%) to get Cash Tax Expense (if gain) or Cash Tax Benefit (if loss). Step 2 (Calculate Cash Flow After Taxes): Cash Flow After Taxes = Sales Price - Cash Broker Fee -/+ Cash Tax Expense or Benefit. (Crucial: Do NOT subtract Tax Basis in Step 2!)

Slide 37 Discussion Prompt: Why does the Year 4 Asset Sale ($2,300 sales price, $500 broker fee, 25% tax rate) produce a +$50 Cash Tax BENEFIT under SLN ($1,850 net cash flow), but Cash Tax EXPENSES under DDB ($1,674 net cash flow) and MACRS ($1,782 net cash flow)?

Under SLN, Year 4 Tax Basis is still relatively high ($2,000), so selling for $2,300 minus a $500 fee yields a -$200 Pretax Loss ($2,300 - $2,000 - $500 = -$200), creating a +$50 tax shield (25% x $200) that reduces the firm's taxes ($2,300 - $500 + $50 = $1,850). Under DDB (Tax Basis $1,296) and MACRS (Tax Basis $1,728), faster early depreciation lowered the tax basis below the $1,800 net proceeds, resulting in taxable gains (+$504 and +$72) and tax expenses (-$126 and -$18).

How does Hall and Jorgenson's "Tax Policy and Investment Behavior" (1967) explain why firms still prefer MACRS/DDB over SLN despite a higher tax bill on Year 4 resale?

Hall and Jorgenson proved that accelerated depreciation (MACRS/DDB) front-loads tax deductions into Years 1 and 2. Because of the time value of money (Capital Allocation Principle #3), saving taxes in Years 1-2 is worth more in present value than paying slightly more tax upon resale in Year 4.

What are the 4 Capital Budgeting Decision Models previewed on Slide 38 for Session 11?

(1) Net Present Value (NPV), (2) Internal Rate of Return (IRR), (3) Payback Period, and (4) Profitability Index (PI).