Finance - 07 Topic - Capital budgeting: cash flow estimation and risk

What are Flotation Costs consist of ?

(1) direct expenses such as printing costs and brokerage commissions, (2) any price reduction due to increasing the supply of stock, and (3) any drop in price due to informational asymmetries.

What types of Depreciation do we have?

* The prime cost method aka the straight line method * The diminishing value method

What is The prime cost method of Depreciation?

* The prime cost method assumes that the value of a depreciating asset decreases uniformly over its effective life.

What is Typical project cash flows consist of?

*Initial Outlays (Property, plant, equipment, R&D, working capital), *Annual Cash Flows (Incremental revenues / savings, incremental costs, taxes) *Shutdown cash flows (asset disposal and related taxes, recovery of working capital investment)

What is Cannibalization?

- refers to a reduction in sales volume, sales revenue, or market share of one product as a result of the introduction of a new product by the same producer - a new store that is close to its existing stores, then the new store might attract customers who would otherwise buy from the existing stores, reducing the old stores' cash flows.

Which costs should or should not be included in a capital budgeting analysis ?

-Capital budgeting analysis should only include those cash flows which will be affected by the decision. -Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. -Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and -externalities are the cash flows (both positive and negative) to other projects that result from the firm taking on this project. Opportunity and externalities cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis.

What is the payback, or payback period?

-It is the number of years it takes a firm to recover its project investment. -It can be calculated with either raw cash flows (regular payback) or discounted cash flows (discounted payback). -It does not capture a project's entire cash flow stream and is thus not the preferred evaluation method. Note, however, that the payback does measure a project's liquidity, and hence many firms use it as a risk measure.

Independent projects; mutually exclusive projects

-Mutually exclusive projects cannot be performed at the same time. We can choose either Project 1 or Project 2, or we can reject both, but we cannot accept both projects. -Independent projects can be accepted or rejected individually.

What are discounted cash flow (DCF) evaluation techniques?

-The net present value (NPV) -Internal rate of return (IRR) These are called discounted cash flow DCF methods because they explicitly recognize the time value of money.

What are normal cash flow projects?

A project if one or more cash outflows (costs) are followed by a series of cash inflows.

Why is it true, in general, that a failure to adjust expected cash flows for expected inflection biases the calculated NPV downward?

According to NPV assumption, all the cash flows are discounted on company's cost of capital. If company fails to adjust expected inflection on their cost of capital then the cost of capital which the company is using to discount expected cash flows will be lower than the inflection adjusted cost of capital. As company is using lower cost of capital rate (without adjusting inflection on their cost of capital) to discount their cash flows, the discounted cash flow will be higher and calculated NPV (Sum of discounted cash flows - Project initial cost) will be lower.

What is risk-adjusted discount rate?

An estimation of the present value of cash for high risk investments. A very common example of risky investment is the real estate. Risk adjusted discount rate is representing required periodical returns by investors for pulling funds to the specific property.

What is beta (or market) risk?

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. -it is the risk that a company contributes to a well diversified portfolio.

Which of the following variables would you consider most important to examine in a sensitivity analysis of NPV on a project proposal for a new product? a. growth rate of sales b. allowable annual depreciation deductions on equipment purchased for the project

Correct choice is a growth rate of sales. Given reasonable certainty about the initial cost of the equipment, annual depreciation deductions would also be reasonably certain. -However, it may be worth considering the effects of using each of the allowable methods for calculating the deduction (e.g. prime cost versus diminishing value in Australia). Growth in sales may be much more difficult to forecast accurately. By examining the sensitivity of NPV to changes in the sales growth rate we can see how the project will perform under a range of sales growth conditions. If the degree of sensitivity is very high, we may decide to do more market research. Alternatively, we might find that even under very pessimistic growth rate assumptions the project's NPV is still acceptable. In this case we might decide that the project is robust.

Explain how net operating working capital is recovered at the end of a project life, and why it is included in a capital budgeting analysis.

In order to support the new projects additional inventories are required and firm gets its additional inventories from its vendors as a result account payable as well as accruals increases. While because of the expansion of company towards new projects company's revenue also increase and tie up as additional accounts receivable. Therefore, the difference between increase in operating current assets and the increase in operating current liabilities is the change in net operating working capital. At the end of the project's life all the additional account receivable are collected where as all additional inventories will be used. As all receivable will be collected, all accruals and payable will be paid by the end of projects. In this way new operating working capital is recovered at the end of a project life.

How do Tax laws affect cash flow analysis?

It affects it in two ways: (1) taxes reduce operating cash flows, and (2) tax laws determine the depreciation expense that can be taken in each year.

what is A staged decision tree?

It divides the analysis into different phases. At each phase a decision is made either to proceed or to stop the project. These decisions are represented on the decision trees by circles and are called decision nodes. They are also called strategic options if they are associated with large, strategic projects rather than routine maintenance projects. Finally, they are also called "real" options because they involve "real" (or "physical") rather than "financial" assets. Many projects include a variety of these embedded options that can dramatically affect the true NPV.

In what sense is a reinvestment rate assumption embodied in the Internal rate of return IRR method?

It involves compound interest, This method assumes reinvestment at the IRR.

In what sense is a reinvestment rate assumption embodied in the NPV method?

It involves compound interest, This method assumes reinvestment at the cost of capital

What is sensitivity analysis

It involves determining the extent to which cash flows change, given a change in one particular input variable

What is scenario analysis

It involves picking several points on the various probability distributions and determining cash flows or rates of return for these points.

What is An investment timing option ?

It involves the possibility of delaying major expenditures until more information on likely outcomes is known. The opportunity to delay can dramatically change a project's estimated value.

What is simulation analysis

It involves working with continuous probability distributions, and the output of a simulation analysis is a distribution of net present values or rates of return. Simulation analysis is expensive. Therefore, it would more than likely be employed in the decision for the $200 million investment in a satellite system than in the decision for the $12,000 truck.

What is Opportunity Cost

It is a cash flow that a firm must forgo to accept a project. For example, if the project requires the use of a building that could otherwise be sold, the market value of the building is an opportunity cost of the project. Or the loss of other alternatives when one alternative is chosen.

What is Replacement chain?

It is a method of comparing mutually exclusive projects that have unequal lives. Each project is replicated such that they will both terminate in a common year.

What are Non-normal cash flow projects?

It is a pattern of cash flows in which the direction of cash flows changes more than once. It is also termed as unconventional cash flow. Non-normal cash flow stream leads to what is called multiple-IRR problem. Capital projects with NNCF have a large cash outflow either sometime during or at the end of their lives.

What is Scenario analysis?

It is a risk analysis technique in which the best- and worst-case NPVs are compared with the project's base-case NPV.

What is Monte Carlo simulation?

It is a risk analysis technique that uses a computer to simulate future events and thereby estimate a project's profitability and riskiness.

What is Sensitivity analysis?

It is a technique that shows how much a project's NPV will change in response to a given change in an input variable, such as sales, when all other factors are held constant.

How can the WACC be both an average cost and a marginal cost?

It is an average cost because it is a weighted average of the firm's component costs of capital. However, each component cost is a marginal cost; that is, the cost of new capital. Thus, the WACC is the weighted average marginal cost of capital.

How is cost of preferred stock, rps calculated?

It is calculated by dividing the annual dividend payment on the preferred stock by the preferred stock's current market price. Note that no tax adjustments are made when calculating the component cost of preferred stock because, unlike interest payments on debt, dividend payments on preferred stock are not tax deductible.

What are costs of new external common equity?

It is higher than that of common equity raised internally by reinvesting earnings. Projects financed with external equity must earn a higher rate of return, since the project must cover the flotation costs.

What is expansion project

It is one in which new sales are generated.

what is An abandonment option ?

It is the ability to discontinue a project if the operating cash flow turns out to be lower than expected. It reduces the risk of a project and increases its value. Instead of total abandonment, some options allow a company to reduce capacity or temporarily suspend operations.

What is Crossover rate ?

It is the cost of capital at which the net present values of two projects are equal. It is the point at which the net present value profile of one project crosses over (intersects) the net present value profile of the other project.

What is the internal rate of return IRR?

It is the discount rate that equates the present value of the expected future cash inflows and outflows. -IRR measures the rate of return on a project, but it assumes that all cash flows can be reinvested at the IRR rate.

What is Salvage Value?

It is the market value of an asset after its useful life. Salvage values and their tax effects must be included in project cash flow estimation.

What is a flexibility option ?

It is the option to modify operations depending on how conditions develop during a project's life, especially the type of output produced or the inputs used

What is capital budgeting?

It is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure. This process is of fundamental importance to the success or failure of the firm as the fixed asset investment decisions chart the course of a company for many years into the future

What is cost of preferred stock, rps?

It is the rate of return required by the holders of a company's preferred stock. The cost of preferred stock, rps, is the cost to the firm of issuing new preferred stock.

What is Profitability Index

It is the ratio of the present value of future cash flows to the project's initial cost. It shows the relative profitability of any project. A profitability index greater than 1 is equivalent to a positive NPV project.

What is Weighted average cost of capital, WACC after-tax cost of debt, rd(1 − T)?

It is the relevant cost to the firm of new debt financing. Since interest is deductible from taxable income, the after-tax cost of debt to the firm is less than the before-tax cost. Thus, rd(1 - T) is the appropriate component cost of debt (in the weighted average cost of capital).

What is Stand-alone risk ?

It is the risk a project would have it it were held in isolation. It views a project's risk in isolation, hence without regard to portfolio effects

What is Weighted average cost of capital, WACC?

It is the weighted average of the after-tax component costs of capital debt, preferred stock, and common equity. It is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital.

What is within-firm risk, also called corporate risk?

It views project risk within the context of the firm's portfolio of assets -It is the risk that a project contributes to a company after taking into consideration the cash flows of the company's other projects; because projects are not perfectly correlated, corporate risk usually will be less than stand-alone risk.

What is net present value NPV?

NPV is the present value of the project's expected future cash flows (both inflows and outflows), discounted at the appropriate cost of capital. -NPV is a direct measure of the value of the project to shareholders

Why is it true, in general, that a failure to adjust expected cash flows for expected inflation biases the calculated NPV downward?

Since the cost of capital includes a premium for expected inflation, failure to adjust cash flows means that the denominator, but not the numerator, rises with inflation, and this lowers the calculated NPV.

Explain why the NPV of a relatively long-term project is more sensitive to changes in the cost of capital than is the NPV of a short-term project?

The NPV is obtained by discounting future cash flows, and the discounting process actually compounds the interest rate over time. Thus, an increase in the discount rate has a much greater impact on a cash flow in Year 5 than on a cash flow in Year 1.

What is NPV profile?

The NPV profile is a graph that illustrates a project's NPV against various discount rates, with the NPV on the y-axis and the cost of capital on the x-axis

What is cost of common equity (or cost of common stock), rs

The cost of new common equity, re, is the cost to the firm of equity obtained by selling new common stock.

Why are interest charges not deducted when a project's cash flows are calculated for use in a capital budgeting analysis?

The costs associated with financing are reflected in the weighted average cost of capital. To include interest expense in the capital budgeting analysis would "double count" the cost of debt financing.

Target capital structure

The target capital structure is the relative amount of debt, preferred stock, and common equity that the firm desires. The WACC should be based on these target weights.

What are Flotation Costs?

They are the costs that the firm incurs when it issues new securities. The amount actually available to the firm for capital investment from the sale of new securities is the sales price of the securities less flotation costs.

What is Net operating working capital changes

They are the increases in current operating assets resulting from accepting a project less the resulting increases in current operating liabilities, or accruals and accounts payable.

What are managerial options aka Real options?

They give opportunities to managers to respond to changing market conditions.

The modified internal rate of return MIRR

assumes that cash flows from all projects are reinvested at the cost of capital as opposed to the project's own IRR. This makes the modified internal rate of return a better indicator of a project's true profitability.

What is Incremental cash flow

is the additional operating cash flow that an organization receives from taking on a new project. A positive incremental cash flow means that the company's cash flow will increase with the acceptance of the project. Are those cash flows that arise solely from the asset that is being evaluated.

What are Sunk costs (also known as retrospective costs)?

It is one that has already occurred and is not affected by the capital project decision. They are not relevant to capital budgeting decisions. -are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken.

What is Externality?

It is something that is external to the project but occurs because of the project. For example, cannibalization occurs when a project's product reduces the company's sales of similar products. The effects of a project on other parts of the firm or on the environment.

What is Project cash flow

It is the free cash flow generated by the project.

What are Real options?

They occur when managers can influence the size and risk of a project's cash flows by taking different actions during the project's life. They are referred to as real options because they deal with real as opposed to financial assets.

What are strategic options aka Real options?

They often deal with strategic issues.

What is accounting income

reports accounting data as defined by Generally Accepted Accounting Principles (GAAP). Generally recognizes realized gains and losses, and does not recognize unrealized gains and losses.

What are embedded options aka Real options?

they are a part of another project.

How do you calculate prime cost depreciation?

you claim a fixed amount each year based on the following formula: Asset's cost × (days held/365) × (100%/asset's effective life)

What does Project net cash flow reflects ?

(1) cash outlays for fixed assets, (2) sales revenues, (3) operating costs, (4) the tax shield provided by depreciation, and (5) cash flows due to changes in net working capital. It does not include interest payments, because they are accounted for by the discounting process. If we deducted interest and then discounted cash flows at the WACC, this would double-count interest charges.

what is a growth option?

A growth option occurs if an investment creates the opportunity to make other potentially profitable investments that would not otherwise be possible. These include (1) options to expand the original project's output, (2) options to enter a new geographical market, (3) options to introduce complementary products or successive generations of products.

What is replacement project?

It is one in which an existing machine is replaced with a more efficient one—new sales might not be created, but cash flows improve because of the more efficient machine.

What is the basis for this emphasis on cash flows as opposed to net income?

Net income basically shows the income which the project or company get after deducting cost of goods sold, selling and general expenses, depreciation, amortizations, interest (if any), and tax from Revenue. -Operating Cash flows shows the real picture of cash available because in cash flows non cash expenses items such as depreciation and amortization are add back. Further, interest expense is not operating activity; it is financing activity which is not included on operating cash flow. Therefore, company emphasis on cash flows as opposed to net income.

What types of projects require the least detailed and the most detailed analysis in the capital budgeting process?

Projects requiring greater investments or that have greater risk should be given detailed analysis the capital budgeting process.

What is Reinvestment rate assumption?

The mathematics of the NPV method imply that project cash flows are reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR. Since project cash flows can be replaced by new external capital that costs r, the proper reinvestment rate assumption is the cost of capital, and thus the best capital budget decision rule is NPV.

What is the diminishing value method of Depreciation?

The method assumes that the value of a depreciating asset decreases more in the early years of its effective life.