BUSI 530 Chapter 9
If the cost of input is $1,000,000 this year; if you project inflation to be 3% annually, what would be an appropriate forecast for the cost of that input in year 4?
$1,125,508 Reason: Correct. $1,000,000 × (1 + 0.03)^4 = $1,125,508.
A project generates revenues of $5,000, costs of $3,000, and taxes of $700. What is the project's operating cash flow?
$1,300
A project generates revenues of $5,000, costs of $3,000, and taxes of $700. What is the project's operating cash flow?
$1,300 Reason: Correct. $5,000 − $3,000 − $700 = $1,300.
A project generates a net profit of $1.8 million and a depreciation of $200,000. What is the project's operating cash flow?
$2 million Reason: Operating cash flow = net profit + depreciation = $2 million
Andersen Corp will undertake a project that will produce cash flows of $50,000 in year 1, $60,000 in year 2, $70,000 in year 3, $75,000 in year 4, and $68,000 in year 5, what is the present value of those cash flows if Andersen's required rate of return on the project is 15%?
$211,562.53; 50000/(1.15) + 60000/(1.15)2 + 70000/(1.15)3 + 75000/(1.15)4 + 68000/(1.15)5 = $211,562.53.
At the end of a project, a firm's investment has a salvage value of $4 million. The firm will pay taxes of $0.5 million on the sale of the equipment from the investment. What is the net cash flow to the firm?
$3.5 million. Net cash flow = salvage value − tax on gain = $4 million − $0.5 million = $3.5 million.
A project generates revenues of $1.4 million, cash expenses of $1 million, and taxes of $100,000. What is the operating cash flow?
$300,000 Reason: Operating cash flow = revenues - cash expenses - taxes = $1.4 million - $1 million - $100,000 = $300,000
Smith Industries plans to sell an asset at the end of a 5-year project for $250,000. The book value of the asset at that time will be $125,000. The marginal tax rate is 35%. How much tax will Smith pay on the sale, and what will be its net proceeds (cash inflow)?
$43,750; $206,250 Reason: Correct. Tax = (250,000 − 125,000) × 0.35 = 43,750; Net proceeds = 250,000 − 43,750.
Which of the following are commonly made mistakes that managers make in regard to working capital and forecasting project cash flows?
- forgetting that working capital may change during the life of the project - forgetting about working capital entirely - forgetting that working capital is recovered at the end of the project
The Tax Cuts and Jobs Act allows companies to take bonus depreciation sufficient to write off what percent of investment immediately?
100%
Mutually exclusive investments
2 different choices for the assembly lines that will make the same product, & a restaurant or gas station on the same piece of land.
Bonus depreciation is a temporary provision of the Tax Cuts and Jobs Act. It is scheduled to be phased-out starting in
2023
If NPV is positive, the project should be ______.
Accepted
Payback period tells the time it takes to break even in an _________ sense.
Accounting
How does the timing and the size of cash flows affect the payback method?
An increase in the size of the first cash inflow will decrease the payback method, all else held constant
Weaknesses of Discounted payback period
Arbitrary cutoff date, exclusion of some cash flows, and loss of simplicity as compared to the payback method
Decision making process for accepting and rejecting projects
Capital budgeting
Capital budgeting decision method finds the present value of each cash flow before calculating a payback period
Discounted payback period
Length of time until the sum of the discounted cash flows is equal to the initial investment.
Discounted payback period
Discounted payback period tells the time it takes to break even in an _______or financial sense.
Economic
True or false: Financing costs like interest and principal payments on borrowed funds must be included in the incremental cash flows for the project.
FALSE - Financing costs are not included in a project's incremental cash flows because the investment decision needs to be separated from the financing decision. The project should be treated as if it were all-equity financed when calculating cash flows.
Discounted payback rule has an objective benchmark to use in decision making. True/False
False
Investing more money in a project is a guarantee of greater profits.
False
Profitability index is calculated by dividing the PV of the ______ CF by initial investment.
Future
Most important alternative to NPV is the ____ method.
IRR
Point at which the NPV profile crosses the horizontal axis is the:
IRR
Budgeting methods are most used by the firms in the US and Canada
IRR & NPV
An ______ project does not rely on the acceptance or rejection of another project
Independent
The point at which the NPV profile crosses the horizontal axis is the:
Internal Rate of Return
Which of the following are true regarding the inclusion of working capital in project cash flows?
Investment in working capital may change over the life of the project. Investment in working capital is a cash outflow. Recovery of working capital is a cash inflow. Invested working capital is recovered by the end of the project.
Which of the following is true of a project's terminal cash flow?
It may include the recovery of working capital investment. It may be due to the sale of a project asset. It may be positive or negative. It may be due to final cleanup or recovery costs.
If a project has multiple internal rates of return, which of the following methods should be used?
NPV & MIRR
When cash flows are conventional, NPV is ________ if the discount rate is above the IRR.
Negative
Which of the following will correct the effect of depreciation?
Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (tax rate × deprecation). Operating cash flow = after-tax profit + depreciation. Operating cash flow = net income + depreciation.
Which of the following formulas can be used to ensure that depreciation is not included in a project's operating cash flows?
Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (tax rate × deprecation). Operating cash flow = net income + depreciation. Operating cash flow = after-tax profit + depreciation.
Which of the following formulas can be used to ensure that depreciation is not included in a project's operating cash flows?
Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (tax rate × depreciation). Operating cash flow = revenues − cash expenses − taxes. Operating cash flow = after-tax profit + depreciation.
Capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.
Payback method
When cash flows are conventional, NPV is ______.
Positive for discount rates below the IRR, equal to zero when the discount rate equals the IRR, and negative for discount rates above the IRR.
In capital budgeting, the net ______ determines the value of a project to the company.
Present Value
The IRR rule can lead to bad decisions when _____ or ______.
Projects are mutually exclusive, cash flows are not conventional.
If NPV is negative, the project should be _______.
Rejected
Which of the following forecasted components of project cash flow should be adjusted directly to change with inflation from year to year?
Revenue Expenses
NPV accounts for the size of the project and eliminates the effects of _______
Scale
The payback period rule ____ a project if it has a payback period that is less than or equal to a particular cutoff date.
Suggests accepting
Point at which the NPV profile crosses the vertical axis is the:
Sum of the cash flows of the project.
Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.
True
The crossover rate is the rate at which the NPV's of 2 projects are equal.
True
True or false: Project discounted cash flow analysis assumes that cash flows occur at the end of the year even though they are actually spread through the year as sales and expenses actually occur.
True
Two challenges with the IRR approach when comparing 2 mutually exclusive projects are scale and cash flow timing.
True
True or false: Project discounted cash flow analysis assumes that cash flows occur at the end of the year even though they are actually spread through the year as sales and expenses actually occur.
True Reason: Correct. This simplifies our calculations.
IRR is 14%, if required return is 14%, the project's NPV is:
Zero
Which of the following statements about working capital is correct?
a project may have WC outflows early, changing to inflows as WC is recovered
Mutually exclusive investment decisions
a situation in which taking one investment prevents the taking of another.
The cash outflow at the start of a project is termed the initial capital investment, and includes:
any investment in fixed assets required by the project. investments in research and marketing required for the project.
To calculate net present value, you need to discount
cash flows
Which of the items below are the elements that must be included in the calculation of a project's total cash flow?
cash flows from changes in working capital cash flow from capital investments operating cash flow
Weaknesses of the payback method
cash flows received after the payback period are ignored, time value of money principles are ignore, cutoff date is arbitrary
A sunk cost is irreversible; sunk costs
do not affect NPV and should be ignored.
The difference between the nominal discount rate and the real discount rate is
expected inflation
By keeping costs such as interest and principal payments on debt out of project cash flows, you are following a fundamental principle of corporate finance known as the separation of investment and ______ decisions.
financing
IRR continues to be very popular in practice, partly because:
gives a rate of return rather than a dollar value
The present value of all cash flows after the initial investment is divided by the _____to calculate the profitability index.
initial investment
Some examples of indirect effects that could affect incremental cash flows would be
loss of existing store sales by locating a new store too close by release of a product that will generate sales of replacement parts and services in future years cannibalization of existing product sales by introduction of a new product increased sales of an existing product by release of a complementary product
The initial capital investment in a project requires a ______ cash flow. The salvage value from a project involves a ______ cash flow.
negative, positive
Land that is used for a manufacturing facility could also be sold. The ______ cost equals the cash that could be realized from selling the land now instead of using it for the manufacturing facility.
opportunity
Amount of time needed for the cash flows from an investment to pay for its initial cost is the:
payback period
Which of the following statements about nominal versus real cash flows are correct?
real cash flows must be discounted by a real discount rate nominal cash flows must be discounted by a nominal discount rate
According to the basic IRR rule, we should____
reject a project if the IRR is less than the required return.
A project's operating cash flow can be calculated using which of the following equations?
revenues - costs - taxes
The cash flows brought about at the end of a project are called ______ and ______ be included in a project's cash flow forecasts.
terminal cash flows; should
An opportunity cost arises in a project whenever
the project uses an existing asset that could have been sold or put to productive use elsewhere
Cash flows from capital investments + operating cash flows + cash flows from changes in working capital =
total cash flow
3 attributes of NPV are that it:
uses all the cash flows of a project, uses cash flows, & discounts the cash flows properly.
IRR is the discount rate that makes the NPV of a project equal to _______.
zero