FINS1613 Lecture Notes - Lecture 4: Capital Budgeting, Tax Rate, Pro Forma

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16 May 2018
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Chapter 9: Fundamentals of Capital Budgeting
- capital budgeting: process of analysing investment opportunities (forecasting
pojet’s fut oseuees ad deidig hih oes to aept affet
revenue/costs)
- capital budget: lists the projects that a co plans to undertake during the next period
o measure of performance (valuation)- CF, value of a project independent of
the rest of the firm- stand alone principle, effective way to derive
performance estimates- indirect method
- pro-forma statements consist of financial projections under a set of hypothetical
assumptions
o project pro-forma CF analysis:
- stand alone principal: how CF change from undertaking a project- incremental
eaigs: aout  hih a fi’s earnings are expected to change as a result of an
investm decision (profits)- earnings are not actual CF
o incremental earnings for project evaluation consist of any and all changes in
the fi’s fut et opeatig pofit that ae a diet oseuees of taking
the project- ieetal et opeatig pofit ∆i et opeatig pofit fo
undertaking a project
incremental operating Y taxes directly related: incremental earnings
= incremental EBIT*(1 marginal tax rate)
ignore financing costs in evaluating projects- ooig/ledig do’t
affect project value in competitive markets (Law of One Price), then
financing costs do not factor in investm decision
particular mixture of debt and equity a firm actually chooses
to use in financing a project is analysed separately
o incremental earnings + adjustments= incremental CF: for project evaluation
osist of a ad all hages i the fi’s fut CF that ae a diet
consequence of taking the project
direct- compute gross cash received/paid- requires tax paym in
incremental earnings (work through twice)
indirect- adjust incremental earnings for missing cash-related
activities
- stand-alone principle decision rule: project can be evaluated by finding the
incremental CF from undertaking the project and discounting at the rate appropriate
for the project- investm is acceptable if NPV of incremental CF is +ve
- forecasting incremental earnings:
o operating expenses (accounted as expenses as they are incurred) vs capital
expenditures:
o incremental earnings= (incre revenue incre cost depreciation)*(1-tax)
- how to use incremental earnings to forecast the actual CF of the project
o estimating project revenue/costs: new product has initial lower sales
accelerate, plateau decline + avg selling price/cost change o/t +
competition reduces profit margins
o EBIT = incremental revenue incremental costs depreciation
o Ieetal CF: ieetal effet of a pojet o the fi’s aailale ash is
the pojet’s ieetal fee CF FCF
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