CAPITAL BUDGETING

Map Outline
CAPITAL BUDGETING
1 BASICS
1.1 Categories
1.1.1 Replacement Projects to maintain the business
1.1.2 Replacement Projects for cost reduction
1.1.3 Expansion Projects
1.1.4 New markets/products
1.2 Principles
1.2.1 Cash Flows, NOT accounting income
1.2.1.1 Incremental
1.2.1.2 Sunk costs - irrelevant
1.2.1.3 Externalites
effects the accpetance of a project may have on other firm cash flows.
1.2.1.3.1 Negative
1.2.1.3.2 Positive
1.2.2 Cash Flows are based on opportunity costs
1.2.3 Timing
1.2.4 After tax basis
1.2.5 Financing costs reflected in the project's required rate of return
1.3 Depreciation Methods
1.3.1 Straight Line
1.3.2 sum-of-year digit
1.3.3 Unit-of-production & service hours
1.3.4 Accelerated
1.3.4.1 MACRS(Tax)
1.3.4.1.1 Other Capital Property
1.3.4.1.1.1 Double Declining : 3,5,7,10 years
1.3.4.1.1.2 150 percent declinining :15, 20 years
1.3.4.1.1.3 Depreciable basis
1.3.4.1.1.3.1 purchase price + shipping+handling costs
 1.3.4.1.1.3.2 NOT adjusted for salvage value
1.3.4.1.1.4 Half-year convention
1.3.4.1.2 Real Property
1.3.4.1.2.1 27.5 Years
1.3.4.1.2.2 39 Years
1.3.4.2 Double declining
2 Classification of Cash Flows
2.1 Initial Investment outlay
2.1.1 Outlay = FCInv +NWCInv
2.1.2 NWCInv=Δnon-cash current assets - Δnon-debt current liab.=ΔNWC
2.2 After-tax operating CFs
2.2.1 CF =(Sales-Costs-Depreciation)x(1-T)+Dpreciation
2.2.2 CF=(Sales-Cost)x(1-T) +TD
2.3 Terminal year after-tax non-operating CFs
2.3.1 TNOCF=pre-tax cash proceeds from sale of fixed capital +NWCInv - T(Sal-Book value)
3 Capital Projects
3.1 Expansion
3.2 Replacement
3.2.1 Outlay=FCInv + NWCInv - Sal0 + T( Sal0 –B0)
4 Inflation Effects
4.1 Nominal CFs be discounted @nominal discount rate
4.2 Changes in inflation - Expected VS. Actual inflation rate
4.3 Inflation reduces tax saving from depreciation
4.4 Inflation decreases the value of payments to bondholders
4.5 Inflation may affect Revenue & Costs differently
5 The Optimal Project
5.1 Mutual exclusive projects with unequal lives
5.1.1 Least common multiple of lives
5.1.2 Equivalent annual annuity approach
5.2 Capital Rationing
5.2.1 Hard
5.2.2 Soft - additional funds possible
6 Real Options
 6.1 Types
6.1.1 Timing Options
6.1.2 Abandonment Options
6.1.3 Expansion (Call) Options
6.1.4 Flexibility Options
6.1.4.1 Price-setting
6.1.4.2 Production-flexibility (quantity)
6.1.5 Fundamental options
6.2 Value of real options
6.2.1 Determine the NPV without the project
6.2.2 the NPV-option cost + option value
6.3 "Hurdle value"
6.3.1 Use decision trees
6.3.2 Use option pricing model
7 Pitfalls
7.1 Failing to incorporate economic responses
7.2 Misusing standardized templates ->estimation errors
7.3 Pet projects of senior mgt
7.3.1 over optimistic projections
7.3.2 project not be subjected to the same lv of analysis as others
7.4 Basing investment decisions on ROE / EPS
7.5 Using IRR criterion
7.6 Poor Cash Flow estimation
7.6.1 Double count
7.6.2 Fail to include ->inflation
7.7 Misestimation of overhead costs
7.8 Using Incorrect discount rate
7.9 Politics involved with spending the entire capital budget
7.10 No alternative investment ideas
7.11 Proper handling of sunk and opportunity costs
8 Risk Analysis of Capital Projects
8.1 Market Risk Methods
8.2 Stand-alone risk methods
8.2.1 Sensitivity
8.2.1.1 Change ONE variable at a time
8.2.2 Scenario
8.2.2.1 Allow mutiple variables change at once
8.2.2.2 Different scenarios with the likely probability distribution
8.2.3 Monte Carlo/Simulation analysis
8.2.3.1 a specific probability distribution for each input variable
8.2.3.2 randomly draw each input variable from its own distribution
8.2.3.3 with the given values, calculate NPV
8.2.3.4 Repeat 2&3, 10000times
8.2.3.5 Calculate mean, SD, and correlation of NPV with each variable
8.2.3.6 Plot the resulting 10,000NPV, as a probability distribution
Map Outline
CAPITAL BUDGETING
1 BASICS
1.1 Categories
1.1.1 Replacement Projects to maintain the business
1.1.2 Replacement Projects for cost reduction
 1.1.3 Expansion Projects
1.1.4 New markets/products
1.2 Principles
1.2.1 Cash Flows, NOT accounting income
1.2.1.1 Incremental
1.2.1.2 Sunk costs - irrelevant
1.2.1.3 Externalites
effects the accpetance of a project may have on other firm cash flows.
1.2.1.3.1 Negative
1.2.1.3.2 Positive
1.2.2 Cash Flows are based on opportunity costs
1.2.3 Timing
1.2.4 After tax basis
1.2.5 Financing costs reflected in the project's required rate of return
1.3 Depreciation Methods
1.3.1 Financial Reporting
1.3.2 Accelerated
1.3.2.1 MACRS(Tax)
1.3.2.1.1 Half-year convention
1.3.2.1.2 Depreciable basis
1.3.2.1.2.1 purchase price + shipping+handling costs
1.3.2.1.2.2 NOT adjusted for salvage value
1.3.2.2 Double declining
2 Classification of Cash Flows
2.1 Initial Investment outlay
2.1.1 Outlay = FCInv +NWCInv
2.1.2 NWCInv=Δnon-cash current assets - Δnon-debt current liab.=ΔNWC
2.2 After-tax operating CFs
2.2.1 CF =(Sales-Costs-Depreciation)x(1-T)+Dpreciation
2.2.2 CF=(Sales-Cost)x(1-T) +TD
2.3 Terminal year after-tax non-operating CFs
2.3.1 TNOCF=pre-tax cash proceeds from sale of fixed capital +NWCInv - T(Sal-Book value)
3 Capital Projects
 3.1 Expansion
3.2 Replacement
3.2.1 Outlay=FCInv + NWCInv - Sal0 + T( Sal0 –B0)
4 Inflation Effects
4.1 Nominal CFs be discounted @nominal discount rate
4.2 Changes in inflation - Expected VS. Actual inflation rate
4.3 Inflation reduces tax saving from depreciation
4.4 Inflation decreases the value of payments to bondholders
4.5 Inflation may affect Revenue & Costs differently
5 The Optimal Project
5.1 Mutual exclusive projects with unequal lives
5.1.1 Least common multiple of lives
5.1.2 Equivalent annual annuity approach
5.2 Capital Rationing
5.2.1 Hard
5.2.2 Soft - additional funds possible
6 Stand-alone risk
6.1 Sensitivity
6.1.1 Change ONE variable at a time
6.2 Scenario
6.2.1 Allow mutiple variables change at once
6.2.2 Different scenarios with the likely probability distribution
6.3 Monte Carlo/Simulation analysis
6.3.1 a specific probability distribution for each input variable
6.3.2 randomly draw each input variable from its own distribution
6.3.3 with the given values, calculate NPV
6.3.4 Repeat 2&3, 10000times
6.3.5 Calculate mean, SD, and correlation of NPV with each variable
6.3.6 Plot the resulting 10,000NPV, as a probability distribution
7 Determine Discount rate with CAPM
8 Real Options
8.1 Types
8.1.1 Timing Options
 8.1.2 Abandonment Options
8.1.3 Expansion (Call) Options
8.1.4 Flexibility Options
8.1.4.1 Price-setting
8.1.4.2 Production-flexibility (quantity)
8.1.5 Fundamental options
8.2 Value of real options
8.2.1 Determine the NPV without the project
8.2.2 the NPV-option cost + option value
8.3 "Hurdle value"
8.3.1 Use decision trees
8.3.2 Use option pricing model
9 Pitfalls
9.1 Failing to incorporate economic responses
9.2 Misusing standardized templates ->estimation errors
9.3 Pet projects of senior mgt
9.3.1 over optimistic projections
9.3.2 project not be subjected to the same lv of analysis as others
9.4 Basing investment decisions on ROE / EPS
9.5 Using IRR criterion
9.6 Poor Cash Flow estimation
9.6.1 Double count
9.6.2 Fail to include ->inflation
9.7 Misestimation of overhead costs
9.8 Using Incorrect discount rate
9.9 Politics involved with spending the entire capital budget
9.10 No alternative investment ideas
9.11 Proper handling of sunk and opportunity costs