Capital Budgeting PDF

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Summary

some notes on capital budgeting...

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Incremental earnings = Incremental EBIT x (1-EBIT) Marginal tax rate: Calculating free cash flow directly: (revenue – costs – depreciation) x (1 – tax rate) + depreciation – capital expenditure – change in networking capital depreciation tax shield: depreciation x tax rate depreciation have a positive impact on free cash flow as it decreases taxable income Other effects on Incremental Free Cash Flow: 

When computing incremental free cash flows, we should include all changes between the firm’s free cash flows with the project versus without the project.

Opportunity costs: 

Opportunity cost should be included as an incremental cost

Sunk costs: unrecoverable cost. Paid regardless of the decision whether or not to proceed with the project. There they are not incremental. Fixed overhead expense are overhead expenses associated with activities that are not directly attributable to a single business activity but instead affecting many different areas of the corporation. E.g. maintaining salary of CEO. Only include additional overhead expenses that arise because of the addition to take on a project. Liquidation or salvage value:    

Capital gain = sale price – book value Book value = purchase price – accumulated depreciation After-tax cash flow = sale price – (tax rate capital gain)

Planet Enterprises is purchasing a $ 10.5$10.5 million machine. It will cost $ 45 000$45 000 to transport and install the machine. The machine has a depreciable life of 55 years, is using straight-line depreciation, and will have no salvage value . The machine will generate incremental revenues of $ 3.5$3.5 million per year along with incremental costs of $ 1.19$1.19 million per year. Planet's marginal tax rate is 30 %30%.

You are forecasting incremental free cash flows for Planet Enterprises. If Planet Enterprises uses the diminishing value method (with a depreciation rate of instead of straight-line depreciation, how would the incremental free cash flows associated with the new machine change? "The incremental cash flows would increase in the early years of the project and decrease in the latter years of the project, because the diminishing value method results in higher depreciation amounts earlier in the life of the project and lower depreciation amounts later in the life of the project (compared to straight-line depreciation). Overall, the present value of the free cash flows would increase under a diminishing value depreciation schedule."

Incremental earnings = (revenues – cost – depreciation) x (1 - tax rate) Free Cash Flow = incremental earnings + depreciation – capital expenditure – change in networking capital Net Working Capital = current assets – current liabilities = Cash + Inventory + Receivables – Payables...