Flashcards in Week 2 - Capital Budgeting Continued Deck (22)
What adjustments need to be made to Free Cash Flow (FCF) to be accurate? What is the abbreviation for remembering the adjustments to be made? What do we ignore?
OCD - STT
- Capital Expenditure
- Opportunity cost
- Salvage Value
- Terminal value
- Tax-loss carried forward
We ignore sunk costs.
What is the ‘Cost of Capital’ the same as?
The discount rate reflects the Cost of Capital
What is the ‘Discounted cash flow’?
Discounted Cash Flow tells you the current value of an investment after making adjustments for the ‘Time value of Money’.The discounted cash flow is essentially the Net Present Value but doesn’t subtract the initial outlay of the investment.
NPV = Initial cash outlay - DFC
What is the process for calculating capital gains when dealing with ‘Liquidation or salvage value’?
- Book Value = Purchase price - Accumulated depreciation
- Gain on sale = Sale Price - Book Value
After-tax cash flow from asset sale = Sale Price - (Tax rate x Gain on sale)
What is the Terminal Value of a Project?
The cash generated from a project after the forecasting period ha concluded
What are the two ways Terminal Value can be calculated ?
Perpetual Growth model - (The business/project continues to grow at a fixed rate indefinitely)
Exit Multiple - (The business/project is sold after the forecasting period for a multiple of some market metric)
What is the formula to calculate ‘Terminal Value’ for a firm with continuous growth?
Terminal Value = FCF(Desired year of value) x (1+g)/ r-g
What types of errors could occur in NVP estimates and what are they?
Type l Error (A good project is rejected and shouldn’t have been)
Type ll Error (A bad project is accepted and shouldn’t have been)
What three factors contribute to increased uncertainty when analysing a project?
- Overstated revenues
- Understated costs
- Tax increases
3 Responses to uncertainty in project analysis
- Wait for uncertainty to be resolved.
- Reject investment
- Continue with investment
What other methods of Analysis can be used?
- Break even analysis
- Sensitivity analysis
- Scenario analysis
What is Break-Even analysis in relation to project analysis?
The level at which the NPV of the project is equal to 0 (ZERO)
What are the characteristics of Sensitivity analysis in relation to project analysis?
- Shows how changes in an ONE PARTICULAR input variable affect overall NPV.
- All variables are held constant EXCEPT one.
- If one variable is sensitive, more time should be spent ensuring the value of the variable is accurate.
What are two advantages and two disadvantages of sensitivity analysis?
- Provides indication of stand-alone risk
- Identifies dangerous variables
- Ignores the relationship between variables
- Does not indicate if a risk is worth taking
What is elasticity in relation to project analysis? And What is the equation for calculating elasticity?
Elasticity is the change in NPV relative to a 1% increase or decrease in a particular base value (variable). I.e. 1% above and 1% below
Elasticity = (NPV above base - NPV below base/Change in parameter) x Base P/Base NPV
What is ‘Scenario analysis’ in regards to project analysis? And what scenarios are used?
Scenario Analysis examines NVP under several different situations to assess the impact of cash flows in different circumstances.
Worst case: Revenue low, Costs High
Base case: Expected revenue, Expected costs
Best case: Revenue high, costs low
What are the ‘Managerial actions’ in capital budgeting?
-Can adapt after project starts.
-Option to expand
-Option to abandon
-Option to wait
What is ‘Capital rationing’? And what two different forms does it take?
Firms have limited financial resources and must exercise rationing when selecting which and how many projects to undertake.
Soft rationing: the limited resources are self-imposed and temporary.
Hard rationing: capital will never be available for this project.
What is the ‘Profitability Index’? And How is it calculated?
A ratio tool used to analyse the payoff of the investment against the projects costs.
Profitability index = Value Created/ Resources consumed
What are ‘Projects with unequal Horizons’? And how is this issue fixed?
When comparing projects, their timelines will often be different. E.g. length of lease, physical life of asset.
When comparing projects, horizons need to be matched or ‘Equivalent Annual Benefit Method’ applied.
At the start of a project what happens to inventory, accounts receivable and accounts payable?
Inventory - Increases (Buy stock)
Accounts Receivables - Decrease (collect Debt owed to you by customers)
Accounts Payables - Increased (Borrow Cash from a bank)