Fundamentals of Capital Budgeting

What is a Capital Budget?

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

How do we know when to accept a project based on the NPV rule?

Accept a project when the NPV is positive.

What should incremental earnings include?

All incremental revenues and costs associated with the project, including project externalities and opportunity costs, but excluding sunk costs and interest expenses.

What is a sunk cost?

An unrecoverable cost that has already been incurred.

What is Net Working Capital?

Cash + Inventory + Receivables - Payables

What is a project externality?

Cash flows that occur when a project affects other areas of the company's business.

True or False: Actual Capital expenditures are not deducted when computing the free cash flow from incremental earnings.

False; it is deducted.

What is the basic calculation for free cash flow?

Free Cash Flow = (Revenues - Costs - CCA) x (1 - tao) + CCA - CapEx - Change in NWC.

What is the discount rate for a project?

It is its cost of capital.

What needs to be included when choosing between alternatives?

Only the components of free cash flow that differ among the alternatives.

What rule is used to evaluate capital budgeting decisions?

The NPV rule

What should free cash flow also include?

The after-tax liquidation or salvage value of any assets that are disposed of and the resulting tax effects. Also potentially terminal value.

What is an opportunity cost?

The cost of using an existing asset.

What is an unlevered net income?

The net income of a project that doesn't take into consideration financing or interest expenses.

What is Capital Budgeting?

The process of analyzing and choosing investment opportunities.

What are the incremental earnings of a project?

They are the amount by which the project is expected to change the firm's earnings.

How do CCA deductions affect the free cash flow?

Through the CCA tax shield.

What is the first thing that we do when evaluating a capital budgeting decision?

We consider the project on its own, separate from the decision of how to go about financing the project. Interest expenses are ignored for the time being.

How do we estimate taxes for a firm?

We use the marginal tax rate, based on the net income of the firm of the firm's other operations, and any tax loss carry backs or carry forwards.

Is Capital Cost Allowance added back when determining the free cash flow from incremental earnings? If so, why?

Yes it is because CCA is a non-cash deduction.

Are increases in Net Working Capital deducted when computing the free cash flow from incremental earnings?

Yes, they are.