CFA Level II: 21. Corporate Finance - Capital Budgeting

Terminal Year Cash Flow

-After-tax salvage value and return of NWCInv -TNOCF = Sal(T) + NWCInv - T(Sal(T) - B(T)) Sal(T) = pre-tax proceeds from sale of fix capital B(T) = BV of fixed capital sold

Capital Rationing

-Allocation of fixed capital amount among the set of available projects that max shareholder wealth -violates mrkt efficiency: resources not best use -hard cap - budget cant be increased -soft cap - budget can be increased

Operating Cash Flows During Life

-CF = (S - C - D)*(1 - T) + D -CF = (S - C)*(1 - T) + (T*D) S = sales C = cash op costs D = depreciation expense T = marginal tax rate

Claims Valuation

-Calc debt and equity then combo to value co -CF to debt - int and princ paym, disc @ cost of d -CF to eq - div & shr rep, disc @ cost of eq

Economic Income

-EI = CF + (end MV - beg MV) -EI = CF - economic depreciation

Expansion Projects

-Investment in new asset to increase size and earnings STEPS: 1. initial investment outlay 2. operating CF over life 3. terminal year CF

Market Value Added

-NPV based on economic profit -MVA = sum EP(t) / [ (1 + WACC)^t ]

Inflation Considerations

-Nominal & real CFs discounted at respective % -project profitability vs expectations -reduces tax savings from depreciation -decreases value of payments to bondholders -affects revenues and costs differently

Discount Rate and Market Risk

-Systematic - mrkt risk, cannot be diversified -Unsystematic - company specific, can be diver. -Project risk = rRF + Beta(project) * MRP

Real Options - Types

-Timing -Abandonment -Expansion -Flexibility -Fundamental

Sensitivity Analysis

-changing an input (independent variable) to see how sensitive the dependent variable is to input -change one variable at a time

Modified Accelerated Cost Recovery System (MACRS)

-classifies assets into 3- ,5- ,7-, or 10-year classes -assumes asset is put into place at mid-year 1

Scenario Analysis

-considers both sensitivity of some key output variable to changes in a key input variable and probability distribution of these variables -difference - multiple changes in input variable -use base case, best case, and worst case

Incremental Cash Flow Classifications

-initial investment outlay -operating CF over project's life -terminal-year CF

Economic Profit

-profit in excess of the cost of cap inv in project -focus on returns to all suppliers of capital -EP = NOPAT - $WACC

Real Options - Evaluation Types

-project NPV w/out option + est value of option -decision trees -option pricing models

Depreciable Basis

-purchase price + shipping, handling, install -not adjusted for salvage value

Simulation Analysis

-results in prob dist of project NPV outcomes STEPS 1. assume specific prob dist for each variable 2. simulate random draw from dist of each input 3. calc NPV from each variable thats been drawn 4. repeat 10k times 5. calc mean NPV, STDdev, and corr of NPV 6. graph 10K NPV outcomes as prob dist

Initial Investment Outlay

-up-front costs for project (price, shipping, install, invest in NWC) -Outlay = FCInv + NWCInv

Principles of Capital Budgeting

1. Decision based on CFs, not acct income 2. CFs based on opportunity cost 3. Timing of CFs is relevant 4. CFs analyzed after tax 5. Financing costs reflected in req rate of return

Economic Depreciation

Beg MV - End MV Beg MV - PV of rem after-tax CFs

NOPAT

EBIT * (1 - tax)

Equivalent Annual Annuity

Find sequent of equal annual payments with PV that is equal to projects NPV STEPS: 1. find each project's NPV 2. Find EAA with PV = NPV over its life at WACC 3. Select project with highest RAA

Replacement Projects

KEY DIFFERENCES: 1. Reflect sale of old asset in initial outlay calc outlay = FCInv+NWCInv - Sal(0) + T*[Sal(0) - B(0)] 2. Calc Op CFs as CF(new) less CF(old) same calc but delta between new and old 3. Compute terminal year non-op CF same calc but delta at Sal(T) and [Sal(T)-B(T)]

Initial Investment Outlay - Net Working Capital Investment

NWCInv = (change in non-cash current asset) - (change in non-debt current liab) -positive = outflow, additional financing required -negative = inflow, frees up cash

Accounting Income

Reported net income on FS results from project DIFFERENCES FROM ECON INC -acct dep based on orig cost, not MV -financing cost (int exp) sep line item

Least Common Multiples of Lives

STEPS: -have shorter life project = longer life project -at overlap, net the new CF outflow against the last CF inflow of the first period

$WACC

WACC * capital capital = $ of investment