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FINALS - 1ST SEM TER 2021-2022: Valuation, Concepts and Methods

This document provides an overview of the capital budgeting process including its key stages and principles. It discusses evaluating and selecting long-term investment projects to maximize shareholder wealth. The stages include identifying opportunities, estimating cash flows, analyzing investments using discounted cash flow methods, implementing selected projects, and conducting post-audits. Relevant principles include basing decisions on incremental cash flows and timing, and considering financing costs in the hurdle rate. Risk adjustments to cash flows and hurdle rates are also discussed.

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Joanna Malubay
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94 views

FINALS - 1ST SEM TER 2021-2022: Valuation, Concepts and Methods

This document provides an overview of the capital budgeting process including its key stages and principles. It discusses evaluating and selecting long-term investment projects to maximize shareholder wealth. The stages include identifying opportunities, estimating cash flows, analyzing investments using discounted cash flow methods, implementing selected projects, and conducting post-audits. Relevant principles include basing decisions on incremental cash flows and timing, and considering financing costs in the hurdle rate. Risk adjustments to cash flows and hurdle rates are also discussed.

Uploaded by

Joanna Malubay
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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VALUATION, CONCEPTS AND METHODS

FINALS - 1ST SEMESTER 2021-2022


INSTRUCTOR: ALEXANDRA SANSAN

9 November 2021
Overview of Capital Budgeting
E.1 Capital Budgeting Process
Overview of Capital Budgeting

一 The process of evaluating and selecting the long-term investment projects of the tum

一 The amount of cash the company takes m and pays out to: an Investment affects the amount of cash
the company has available for operations and for other activities of the company

一 One 0f the primary goals of capital budgeting is to implement capital projects that maximize
shareholder wealth

Stages of Capital Budgeting

A capital budget involves five major stages:

1. Identify and define potential Investment opportunities.


2. Estimate the cash inflows and outflows and risk for each potential investment-
3. Analyze the profitability of each potential investment using discounted cash flow methods and select the
iRestments that maximize profitability.
4. implement the selected investments.
5. Monitor the investments and conduct a postaudit by comparing actual results to the estimated results to
evaluate the effectiveness and efficiency of each investment.

Capital Budgeting Principles

● Decision making is based on cash flows and timing of cash flows


一 Cash flows include incremental costs and opportunity costs but exclude sunk costs
一 Cash flows are considered on an after-tax basis
一 Financing costs are considered in the hurdle rate but not considered a cash outflow

Relevant and Incremental Cash Flows

● The cost of the investment is considered as a cash outflow at inception. rather than as a cost
depreciated over the life of the asset.
● The cost of any debt associated with the investment is included in the hurdle rate used when
computing discounted cash flows.

● Incremental cash flow is the net increase in operating cash flow during the life of the new capital
investment.
● A positive incremental cash flow demonstrates that the capital project adds value to the business by
increasing the assets of the company.
● Incremental cash flows should include opportunity costs, which are the co§t of forgoing the next best
alternative when making a decision.
● incremental cash flows should not include sunk costs.
一 Sunk costs are costs incurred in the past that cannot be changed by a current investment
decision.
Cash Flow Effects

● Direct Effect: payment, receipt, or commitment of cash directly related to the capital investment

● Indirect Effect: transactions indirectly associated with the capital project or transactions which
represent noncash activities that produce a cash benefit or obligation

Illustration 1 Cash Flow Effects

Depreciation is a noncash expense taken as a tax deduction. Depreciation reduces the amount of taxable
income and. consequently, the related taxes. The reduced tax bill resulting from increased depreciation
expense associated with a new project decreases the cash paid out. This type of effect is called an indirect
effect (or tax effect) of capital budgeting.

Stages of Cash Flow

● Cash flows are categorized in three general stages:


一 Inception of the project (time period zero)
一 Operations
一 Disposal of the project

Inception of the Project (Time Period Zero)


The initial cash outlay for the project is often the largest cash outflow during the project's life.

● Cash flows at the time of the initial investment include:


一 Direct Cash Flows: the acquisition cost of the asset
一 Indirect Cash Flows: working capital requirements or disposal of the replaced asset
Working Capital
The firm may need to increase or decrease working capital to ensure the success of the project.
● Equals current assets minus current liabilities
一 May increase due to increases in payroll, expenses for supplies, or inventory requirements
一 May decrease due to implementation of a just-in-time inventory system
Operations
Ongoing operations of the project will affect both direct and indirect cash flows of the company.
● The cash flows generated from the operations of the asset occur on a regular basis.
一 These cash flows may be the same amount every year (an annuity) or may differ
● Depreciation tax shields create ongoing indirect cash flow effects from tax savings.

Disposal of the Project


Disposal of the investment at the end of the project produces direct and/or indirect cash flows
● If the asset is sold. there is:
一 A direct effect for the cash inflow created on the sale and any cash expenses (e.g., severance
pay)
一 An indirect effect for the taxes due (in the case of gain) or saved (in the case of a loss)
● If the asset is scrapped or donated. there may be:
一 A tax savings (an indirect effect) if the net tax basis is greater than zero tie. the asset has not
been fully depreciated)
● Either type of disposal may result in an Indirect cash inflow as a result of a release of an initial working
capital commitment or a change in working capital commitment (employees may no longer be needed)
Calculation of Pretax and After-Tax Cash Flows
After-tax cash flows are computed using either of the following methods:
Method 1:
● Estimate net operating cash inflows
● Subtract noncash tax-deductible expenses to arrive at taxable income
● Compute income taxes related to a project's income (or loss) for each year of the project's useful life
● Subtract tax expense from net cash inflows to arrive at after-tax cash flows

Method 2:
● Multiply net operating cash inflows by (1 — Tax rate)
● Add the tax shield associated with noncash expenses such as depreciation (depreciation multiplied by
the tax rate)
● The sum of these two amounts will equal the after-tax cash flows
Example 1 cash Flows for Capital Budgeting

Facts: The divisional management of Carlin Company has proposed the purchase of a new machine that will
improve the efficiency of the operations in the company's manufacturing plant. The purchase price of the
machine is $425,000. Costs associated with putting the machine into service include $10,000 for shipping,
$15,000 for installation, and $6,000 for the initial training.

Carlin expects the machine to last six years and to have an estimated salvage value of $7,000. The machine is
expected to produce 4,000 units a year with an expected selling price of $800 per unit and prime costs (direct
materials and direct labor) of $750 per unit.

Tax depreciation will be computed under the accelerated straight-line rules (not MACRS) for five-year property
with no consideration for salvage value tie, the entire asset amount Capitalized will be depreciated). Carlin has
a marginal tax rate of 40 percent.

Required: Calculate cash flows at the beginning of the first year (Year 0), for Years 1-5, and for Year 6, which is
the final year.
Hurdle Rate
● The minimum rate of return management expects to earn on a capital investment
● Set by management
● May differ from project to project depending on:
一 Project risk
一 The company's cost of capital
一 Returns on similar investments
一 Other factors that management believes may affect the investment
Risk Adjustments
● The higher the capital project's risk. the higher the return required by management.
● A higher hurdle rate results in lower discounted cash flows. making a high-risk project appear less
profitable when compared to lower-risk projects discounted using lower hurdle rates.
● An overly high rate may cause management to reject potentially profitable projects and to favor
short-term investments over
● long-term investments.
● Similarly, an overly low hurdle rate could result in the acceptance of projects for which the rate of
return is not compatible with the risk being undertaken.
Effects of Inflation
● The hurdle rate should include the expected inflation rate and should be increased if management
anticipates higher-than-normal inflation.
● Future cash flows should also be adjusted for the effects of expected inflation.

Evaluating Risk in Capital Budgeting


The three types of risk relevant to capital budgeting are:
● Stand-alone Risk: The risk if it was the firm's only investment. The inherent risk of the investment. not
influenced by the relative risk of the entity or the market as a whole.
● Contribution-to—Firm (Corporate) Risk: Reflects the project’s effect on the company as a whole,
considering other investments of the entity. Can be mitigated through project diversification.
● Systematic (Market) Risk: This is risk that cannot be eliminated through capital project diversification. Is
a product of changes in the market. inflation. interest rate fluctuation, and currency fluctuation are the
most common sources of systematic risk.

Adjusting for Risk in Capital Budgeting


The following methods can be used to adjust for higher risk:
● Increasing the hurdle rate used to compute discounted cash flows
● Risk-adjusting the estimated cash flows from the project by reducing estimated cash flows that are less
likely to be incurred or received
● Delaying all cash flows by one year. which results in higher discounting and decreases the value of the
project
● Decreasing the required payback period

Risk Analysis Techniques


● Sensitivity Analysis
一 Used to evaluate how a change in assumptions can affect capital investment analysis results
一 Base model is developed and each variable (interest rates, cash flows. life span) is changed, one
at a time, to model the change in the net results (or project return)
● Scenario Analysis
一 Used to evaluate consequences of an action under a different set of factors
一 Allows more than one variable to change at a time

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