What is capital budgeting
The process of deciding which long-term investments a firm should take
What type of assets does capital budgeting focus on
Long-term assets (usually more than a year)
What are incremental cash flows
Cash flows that only happen if the project is accepted
Key question for including a cash flow
“Will this happen ONLY if we take the project?”
What is the stand-alone principle
Analyze a project by only looking at its own incremental cash flows
What are sunk costs? Include or ignore?
Past costs that cannot be changed.
Ignore them!
What are opportunity costs? Include or ignore?
Benefits you give up by choosing one option over an other.
Include them!
2 Types of side effects in projects
Positive - helps other projects (synergy)
Negative - hurts other projects (erosion)
Why don’t we include financing costs in project cash flows?
Because they are already included in the discount rate
How should inflation be handled?
Nominal CF -> nominal rate
Real CF -> real rate
What is Operating Cash Flow (OCF)?
Cash generated from normal operations
What is included in OCF
- revenues
- costs
- taxes
What is Cash Flow from Assets (CFFA)?
Total cash flow from the project after investments and NWC changes
What happens to NWC at the end of a project?
It is recovered (cash inflow)
What is Capital Cost Allowance (CCA)?
Depreciation used for tax purposes in Canada
Why is depreciation important in capital budgeting?
It reduces taxes (creates a tax shield)
What is the depreciation tax shield
Tax savings from depreciation
What problem occurs with projects of unequal lives
NPV comparison can be misleading
How do we compare projects with unequal lives
- Replacement chain method (repeat projects forever, find PV of that perpetuity)
- Matching Cycle (repeat projects until they begin and end at the same time, find NPV of repeated projects)
- Equivalent Annual Cost (EAC) (equation)
What is Equivalent Annual Cost (EAC)?
Annual cost that has the same present value as the project
