Chapter 14

Question 1

Outline the basic framework for capital expenditure analysis. - General Guidelines

Answer 1

1. Estimate all cash flows on an after-tax basis and use an after-tax discount rate.
2. Use appropriate cash flow estimates that represent the marginal or incremental cash flows arising capital budgeting decisions. These are the additional cash flows that result from capital budgeting decisions.
3. Do not include associated interest and dividend payments in estimated project cash flows; these should be accounted for in the discount rate.
4. Adjust cash flows to reflect any additional working capital requirements, particularly the initial outlay and the terminal cash flow.
5. Treat sunk costs, costs that have already been incurred and cannot be recovered regardless of the capital budgeting decision, as irrelevant. We are concerned only with future cash flows
6. Although sunk costs are irrelevant, opportunity costs should be factored into cash flow estimates. Opportunity costs are cash flows that must be forgone as a result of an investment decision.
7. Determine the appropriate time horizon for a project.
8. Ignore intangible considerations that cannot be measured unless their impact on cash flows can be estimated. Intangibles should not be used to justify poor projects.
9. Ignore externalities, which are consequences that result from an investment that may benefit or harm unrelated third parties.
10. Consider the effect of all project interdependencies on cash flow estimates. Undertaking a negative NPV project could lose money in the short-term, but give the firm the option to generate value in the future
11. Treat inflation consistently: discount nominal cash flows with nominal discount rates, or real cash flows with real discount rates.
12. Undertake all social investments required by law. Many social and infrastructure projects must be undertaken even though they have negative rates of return or no definable impact on the value of the firm.

Question 2

The Initial After-Tax Cash Flow (CF0)

•All evaluation approaches (NPV, IRR, discounted payback and PI) require the same data:

Answer 2

CF0 = the estimate of the initial outlay

CFBT(1 – T) = the net incremental after-tax cash flows

k = the cost of capital

n = the estimate of the useful life

ECFn = the ending cash flow

T = the corporate tax rate

d = the Capital Cost Allowance rate

Question 3

ESTIMATING AND DSICOUNTING CASH FLOWS

the initial after-tax cash flow (CFo) is

Answer 3

• The basic cash flow pattern has an initial investment and t = 0, an annual stream of after-tax cash flow benefits at each time period, and, at the end of the useful life, ending cash flow benefits after-tax
• The NPV is given by Equation 14-5:

Question 4

What is marginal or Incremental cash flows

Answer 4

the additional cash flows that result from cpatial budgeting decisions, generated by new projects

Question 5

what are sunk costs

Answer 5

costs that have already been incurrred, cannot be recovered, and should not influencence current capital budgeting decisions

Question 6

what is opportunity cost

Answer 6

cash flows that must be forgone as the resutl of invetment decision

Question 7

what are externalities

Answer 7

the consequences that result forman investrment that may benefit or harm unrelated thrid parties

Question 8

what is the initial after-tax cash flow (CF0)

Answer 8

the total cash outlay required to initiate an investment project, including the change in net working capital and associated opportunity costs

Question 9

what is captial cost (C0)

Answer 9

all costs incurrred to make an investment operational, such as macinery installation expenses, land-clearing csots, and so; these can be deprecaited for tax purposes

Question 10

what is expected annual after-tax cash flows (CFt)

Answer 10

the cash flows that are estimated to occur as a result of the investment decision, comprising the assocaited expected incremental increase in after-tax opearting incoem and any incremental tax savings (or additional taxes paid) that result from the initial investment outlay

Question 11

what is the equation for NPV

Answer 11

NPV = PV(annual CFs) + PV(ECFn) - CF0

Question 12

the basic cash flow pattern has what

Answer 12

an initial investment and t = 0,

an annual stream of after-tax cash flow benefits at each time period

and, at the end of its useful life, ending cash flow benefits after-tax

Question 13

what is the equation for the initial after -tax cash flow (CF0)

Answer 13

add equation 14-1

Question 14

what does this equation represent?

14-2

add

Answer 14

add

Question 15

what is the equaiton for ending (or Terminal) Afterr-tax cas flow (ECFn)

Answer 15

14-4 add equation

Question 16

if there are tax issues, the ECF must be modified. what is the equation to adjust for any taxes payable on the salveage value due to captial gains or recapture of depreciation

Answer 16

add equation 14-3

Question 17

once you have estimated the cash flows what should happen

Answer 17

1. determine their after-tax vaues
2. determine their peresent value
3. sum the present value to determine the NPV

the equation is:

NPV = PV (Annual CFs) + PV (ECFn) - CF0

Question 18

what are the two approaches to determining cash flows?

Answer 18

1. before-tax opearting income (before depreciation) - CCA = taxable income - taxes payable = after-tax income + CCA (Non-cash expense) = Net cash flow
2. Before-tax operating income (beforedepreciation) - taxes payable on operating income = after-tax opearting income + CCA tax savings = Net Cash flow

Question 19

the tax sheild benefit form CCA is equal to what

Answer 19

the corproate tax rate multipled by the CCA amount

T x CCA

Question 20

assuming the firm wil have taxable opearting income in the future, we can predict the maximium amount of CCA the firm can claim from the year of acquisition throuh to infinity what are some of the rules that apply to the CCA

Answer 20

1. the half- year rule is in effectin the first year
2. we assume we calim the maximum CCA in each subsequent year
3. we forecast the tax sheild benefit as: T x CCA
4. tax sheild benfits will be perpetual stream of cash flows that are growing at a constant negative compund growth rate d which is the CCA rate

Question 21

CCA provides large tax shield benefits when

Answer 21

in the early years of an asset’s useful life (it is an accelerated depreciaiton method)

Question 22

what happens with residual values in the asset pool for CCA

Answer 22

residual values remain in the asset pool long after the asset was acquired, which means a firm will never fully recoup the cost of the asset.

as the firm’s asset base ages, cash flwos generated from CCA will not enable the firm to replace the orignal asset

Question 23

the difference between the salvage value and the purchase price is what

Answer 23

the capital gain

Question 24

what part of the capital gain is subject to tax

Answer 24

50% of the realized capital gain is subject to tax at the corporate tax rate

Question 25

NPV =

Answer 25

the PV of after-tax operating cash flows plus the PV of the CCA tax sheild benefits Plus the PV of the ending cash flow (which is the salvage value plus the recovery fo the net working capital investment) minus taxes payable on the realized capital gain and /or the recapture of depreciation minus the initial investmnet in the asset (both the purcahse price and the investment in net working capital)

Question 26

why do you stress test NPV models

Answer 26

to determine the senseitivity of hte decsion to input variables is an important part of risk assessment

Question 27

what are the two common approaches for stress testing NPV

Answer 27

1. senszitivity analysis 2. Scenario analysis

Question 28

what is sensitivity analysis

Answer 28

is an examiniation of how an investment's NPV changes as the value of one input at a time is changed

Question 29

what is scenario analysis

Answer 29

is an examination of how an invesetment's NPV changes in response to varying scenarios in terms of one or more estimates, such as sales or costs

Question 30

what is ending (or terminal) after-tax cash flow (ECFn)

Answer 30

the total cash flow that is expected to be generated in the terminal year of a project, aside fomr that year's expected after-tax cash flow; thje estiamted salvage value of the asset

Question 31

what is salvage value (SVn)

Answer 31

the estimated sale price of an asset at the end of its useful life

Question 32

how do scenario analysis work?

Answer 32

input variables are often given discrete forecast ranges: best case, most likely case, worst case, etc analysts are interestedin what the NPV might be in the worst combination of cases, for example : worst-case opearting cash flows (low), worst-case initial cost(high), and worst-case net working capital investment (high)

Question 33

what is real option value (ROV)

Answer 33

and decision tree analyis have dramatically increased hte understanding of corproate decsion making and the vlaue of flexibility and startegic consdierations.

Question 34

what are decsion trees?

Answer 34

a schematic way to represent alternative decsions and the possible outcomes

Question 35

what are the real options that almost always exist in a capital expenditure decsion

Answer 35

1. Delay - undertake the investment now, or in the future? 2. contingent decisions - will accepting a project generate other projects that are linked or interdependent? 3. redeployment - can resources be put to alternative uses if th eproject does nto proceed as expected? 4. Abandonment - can the project be terminated if expected cash flows do not materialize? 5. improvement - can expected cash costs be lowered thorugh learning as the project is implemented?

Question 36

when would you use the Black=Shcoles option

Answer 36

the binomial or Black-scholes option pricing models can be used only in highly restrictive circumstances

Question 37

What is the NPV break-even point

Answer 37

is the level of annual oeparting cash flow requried for a project to produce an NPV of zero

Question 38

what is the break-even disocunt rate?

Answer 38

the project's IRR

Question 39

what are expansion projects

Answer 39

they add something extra to the firm in terms of sales or cost savings - their new cash flwos are incremental cash flows

Question 40

what are replacement projects?

Answer 40

involve the replacement of an exisiting asset (or assets) with a new one and, in such cases, we must clearly identify the incremental cash flows paying particular attention: 1. the affect on incremental captial cost 2. the effect on the CCA tax sheild. - the equipment to be replaced is normally sold early. - normallyl there are no tax consequences on disposal, expcet when assets ar esodl at a price gwerater than their original cost, which triggers captial gains taxes on the difference

Question 41

how do you calculate the incremental captial cost

Answer 41

purchase price of the new equipment - salveage price of the equipment

Question 42

what happens when an asset is removed form a CCA class?

Answer 42

- there is no CCa in the year of disposal - the UCC of the pool or class is reduced by the disposal value

Question 43

what happens when an asset is added to a CCA class?

Answer 43

- there is 1/2 of the normal CCA on the net additions to the pool in that year - the UCC of hte pool is increased by half of the net addition in the first year, and half of the net additions in the second year

Question 44

what do we do when we have replacement decisions

Answer 44

we must modify the PV of the tax sheild formula to account for the cahgne in the initial outlay and salvage values

Question 45

when can you use the deconstructed NPV model what is the focus on and what is the formula

Answer 45

in replacement decisions - the focus is on the **net change** in operating cash flows, CCA tax shield, ending and initial cash flows add formula

Question 46

what affect can small rates of inflation have

Answer 46

even small rates of inflation over time can have considerable effects on the conomic viability of a project

Question 47

although inflation is often measured by aggregated changes in prices at the reatil (CPI, consumer price index) or wholesale leve, these measure often do what

Answer 47

often they do not reflect price change specific to one company to project

Question 48

inflation must be treated consistently in project evaluation models, either by

Answer 48

1. removing it from the nominal discount rate and using nominal cash flow forecasts 2. leaving the discount rate with an expected inflation component and estimating real (Inflation-adjusted) cash flows

Question 49

**removing expected inflation from the discount rate opiton** if we use non-inflation adjusted (or nominal) forecast cash flows and then disocunt using a nominal disoucnt rate we will do what

Answer 49

over-discount because we are using a higher rate but not inflated cash flow forecasts

Question 50

what should we use if we are using removing expcted infaltion form the discount rate or (using the nominal forecast cash flows)

Answer 50

we should use fisher equaiton to estaimte the embedded infalitonary expectations, and then reduce the nominal discount rate by that amount risk-adjusted discount (RADR) = RF+Risk Premium RF= real return + expected inflation rate

Question 51

**what is option 2: inflation adjustement** If you use an unadjusted WACC as the discount rate, then

Answer 51

you must use inflation-adjusted cash flow estiamtes for opearting cash flows - or, if you remove inflation form the discount rate, then you can use nominal cash flow estiamtes for opreating cash flows