Finance Midterm 3

Front 1

Capital Budgeting is

Back 1

the process by which we decide if a project will enhance or destroy company value and thereby shape the firm's future.

(Long term decisions typically)

Front 2

What are the ideal criteria for methods used to evaluate a capital investment project?

Back 2

-include all relevant cash flows

-consider the timing of the project’s cash flows

'--account for the time value of money

-account for the varying levels of risk

-Incorporate the required rate of return (i.e., risk) on the project.

Front 3

Exxon oil, transportation vs exploration is an example of...

Back 3

risk characteristics

Front 4

the most preferred evaluation technique is..

Back 4

NPV--Net Present Value

Front 5

payback period is

Back 5

the number of years required to recover the initial cash outlay.

Front 6

What are the disadvantages of the payback period method?

Back 6

-does not identify the varying levels of risk in a project

-does not account for the timing of the project’s cash flows

-does not account for the varying levels of risk in a project

Front 7

The advantage to using the payback period when evaluating a capital investment project is

Back 7

simple to calculate

Front 8

IRR is

Back 8

the rate of return that the firm earns on its capital projects.

also, the disc. rate that makes the NPV=0

Front 9

Drawback of IRR is...

Back 9

Additive problems in capital-constrained environment

IRR works well only when project cash flows are conventional. (cash flow patterns)

SIGN CHANGES ARE THE BIGGEST PROBLEM

Front 10

The decision rule for the IRR states that when the IRR is greater than ______________ the project should be accepted.

Back 10

The discount rate (aka the required rate)

Front 11

disadvantages to using the IRR when evaluating a capital investment project consist of...

Back 11

-the analyst cannot compare mutually exclusive projects

-the analyst cannot examine unconventional cash flows

-does not consider the time value of money

Front 12

There are two ways to deal with the unequal project lives problem:

Back 12

The replacement chain approach

The Equivalent Annual Annuity (EAA) approach

Front 13

The Net Present Value is a measure of:

Back 13

How much value is added to the firm as a result of undertaking the project.

Which projects should be accepted and rejected.

The value of a project to the firm.

Front 14

The net present value of a project is smaller when:

Back 14

Cash inflows are pushed farther into the future

Front 15

Internal rate of return is calculated by:

Back 15

Finding the discount rate that forces the NPV of the project to zero.

Front 16

If the firm wants to make the profitability index equal to 1 for Project Alpha, the initial outlay has to be:

Back 16

Initial Outlay has to be 50 – 4.83 = 45.17 million.

IO=IO - NPV ... In order to make PI = 1 or NPV = 0,

Front 17

Internal rate of return is calculated by:

Back 17

Finding the discount rate that forces the NPV of the project to zero.

Front 18

Which is NOT a potential problem with the IRR approach to capital budgeting?

Back 18

IRR does not adequately account for risk. NOT A PROBLEM

Because the IRR DOES account for risk

Front 19

another eq for npv...

Back 19

NPV = (PI X IO) – IO

Front 20

If the firm has a maximum capital expenditures budget of $450,000, and if the projects are independent, mutually exclusive, and repeatable, which project(s) should be accepted?

Back 20

Since projects are mutually exclusive, repeated and have different lives, you use EAA to make a decision.

You find EAA by using TVM function. PV = -NPV, N = life of the project, I = discount rate, and FV = 0.

Solve for PMT = EAA. EAA’s are 5,286, 2,919, and 8,327 for Projects 1, 2 and 3 respectively.

Thus you choose Project 3.

Front 21

If the firm has a maximum capital expenditures budget of $450,000, and if the projects are independent and mutually exclusive but not repeatable, which project(s) should be accepted?

Back 21

Projects are mutually exclusive but they are not repeated, so you choose only one project based on NPV.

NPV = (PI X IO) – IO. The NPV’s are 36,000, 12,000 and 20,000 for Projects 1, 2, and 3 respectively.

So you choose Project 1.

Front 22

Number-crunching does

Back 22

NOT make decisions!

Front 23

we are interested in incremental cash flows—

Back 23

those cash flows that result from accepting a project.

Front 24

Incremental cash flows are

Back 24

any additional cash flows, whether in or out of the firm, that are created as a result of our accepting the project. They include any additional revenue, expenses, taxes, or other costs. The net incremental cash flow is the sum of all additional cash flows (i.e., incremental cash in minus incremental cash out).

Front 25

two essential guidelines to follow when considering which cash flows to include in the analysis of a capital investment:

Back 25

1- You have to look at a capital budgeting project from the CEO's office. That is, you need to look at the project from the top of the organization so you can see the "big picture" on how the company will be impacted. Why? Because of point

2:There will always be people trying to allocate cash flows (especially expenses) to your project. Accounting concepts like "overhead allocation" (the allocation of general expenses, such as the cost of corporate headquarters, to individual operating units) do not represent incremental cash flows. Thus, you have to decide what costs and revenues are really attributable to your project and which are not.

Front 26

If your company is planning on launching a new product and that new product is going to steal (or cannibalize) some of the sales of another of the company's products, that loss of sales could

Back 26

be an incidental cost (or incidental loss of revenue) caused by the new product.

Front 27

projects also have indirect, or

Back 27

incidental, cash flows which may be less obvious at first glance.

cannibalization is an example of an incidental cf

Front 28

Unlike sunk costs, opportunity costs

Back 28

do matter in capital budgeting.

Front 29

Recall that for accounting purposes there are two kinds of expenses:

Back 29

current expenses and capital expenses.

Front 30

There are two methods of calculating depreciation expense:

Back 30

MACRS=

Depreciation Expense = cost × percentage

Percentage determined by life

Cost, or basis, never changes

Straight-line=

Depreciation Expense = (cost – salvage)/life

Front 31

Capital expenses DO NOT flow directly to the income statement. Rather, they are included as assets on the balance sheet.

Back 31

assets on the balance sheet.

Front 32

Modified Accelerated Cost Recovery System

Back 32

(MACRS).

better than straight line

n yrs of depreciation=n+1 yrs of depreciation to exhaust the asset

Front 33

straight-line depreciation

Back 33

= (cost - salvage value) / life

Front 34

MACRS is preferred because it

Back 34

depreciates assets more quickly than does the straight-line method (note that it is called accelerated depreciation).

Front 35

Net working capital is defined as

Back 35

current assets minus current liabilities.

Front 36

assets =

Back 36

liabilities + owner's equity.

Front 37

Standard convention:

Back 37

Increases in net working capital represent cash outflows early in the project and cash inflows at the end of the project. At the beginning of the project (time 0), we invest in additional working capital resulting in a cash outflow. At the end of the project we decrease working capital to its previous level, thereby liquidating net working capital and recouping our original investment. Note, however, that there may be cases in which this standard convention does not accurately describe the project being evaluated and may need to be adjusted.

Front 38

Rule:

Back 38

Regardless of how it is accumulated, any net working capital associated with a specific capital project is liquidated at the end of the project's life, resulting in a cash inflow. There are no tax effects associated with working capital build-up or liquidation.

Front 39

the build-up of net working capital is treated as

Back 39

an outflow (frequently at time 0).

By the end of the project, all net working capital associated with the project must be liquidated, resulting in a cash inflow

Front 40

There are two situations in capital budgeting where we have to worry about the impact of taxes:

Back 40

income taxes and taxes on the sale of assets.

Front 41

1-Income tax—usually a fixed marginal rate

2-Tax on sale of equipment is...

Back 41

Calculate Book Value: Cost – Acc. Depr

If BV < sale price, then there is a taxable gain

If BV > sale price, then there is a taxable loss

Front 42

Income taxes and shield

Back 42

The tax savings that result from offsetting positive earnings with negative income are known as a tax shield

Front 43

The rule here with taxes on asset sales is that

Back 43

gains, not revenues, are taxed.

Front 44

How do you calculate the tax effects of the sale of an asset?

Back 44

Multiply the market value minus the book value of the asset by the tax rate.

Front 45

If a company experiences a taxable loss from the sale of an asset:

Back 45

it experiences a tax shield that is counted as a cash inflow.

Front 46

depreciation is a

Back 46

non-cash expense

Front 47

To calculate the cash flow at the end of the life of the project, take:

Back 47

Last Year's Differential Cash Flow + Terminal Cash Flow

Front 48

free cash flow =ATCF=....

Back 48

ATCF = EBIT - Taxes + Depreciation - Change in Net Working Capital

Front 49

we calculate the terminal cash flow as follows:

Back 49

Salvage Value ±Tax Effects of Capital Gain/Loss +Recapture of Net Working Capital =Terminal Cash Flow

Front 50

Differential CF's=

Back 50

Front 51

Terminal CF=

Back 51

=salvage-tax on capital gain+recapture of NW

or

=diff cash flow for that year + recoup NWC

Front 52

Any time you see "simplified" before straight line you will know that

Back 52

it is depreciated to 0

(note: the salvage value that it gives is the "realizable" salvage value(MV), which is what we are going to sell it for, not the book value we are looking for to depreciate it to).

Front 53

What will increase the project's NPV?

Back 53

MACRS method

cuz, If the firm uses MACRS instead of the straight line, the firm has higher NPV since the firm gets tax benefits earlier than the straight-line depreciation method.

Front 54

If the firm uses the simplified straight-line depreciation method rather than the straight-line depreciation method, the NPV will...

Back 54

increase.