FIN 3113 Chapter 10

Relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?

Book value represents the purchase price minus the accumulated depreciation, there will be a tax savings if the book value exceeds the sales price, and taxes are based on the difference between the book value and sales price.

Among the 3 main sources of cash flow, which source is the most important and most difficult to forecast?

Operating cash flows from net sales over the life of the project.

Project Cash Flow

Project Operating cash flow - project change in net working capital - project capital spending

Erosion will ______ the sales of existing products.

Reduce

Fixed Costs

Rent on a production facility and cost of equipment

Example of an opportunity cost

Rental income likely to be lost by using a vacant building for an upcoming project.

____ principle: once the incremental cash flows from a project have been identified, the project can be viewed as a minifirm

Stand-alone

Cash flows should always be considered on a ______ basis

after-tax

Interest expenses incurred on debt financing are _______ when computing cash flows from a project.

ignored

Computation of equivalent annual costs is useful when comparing projects with unequal ______________.

lives

T/F: Opportunity costs can be ignored when determining the financial feasibility of a project.

False

What are considered relevant cash flows?

Cash flows from opportunity costs, cash flows from beneficial spillover effects, & Cash flows from erosion effects.

Sunk Cost

Cost we have already paid or have already incurred the liability to pay. Cannot be changed by the decision today to accept or reject a project.

Operating cash flow is a function of _____

Depreciation, EBIT, Taxes

Incremental cash flows come about as an ____ consequence of taking a project under consideration.

Direct

Operating Cash Flow

EBIT + Depreciation - Taxes

Acct Rec & Accts Pay are not an issue with project cash flow estimation unless changes in ________ are overlooked.

Net working capital

Increase in depreciation expense will ______ cash flows from operations.

increase

if tax rate increases, the value of depreciation tax shield will ______.

increase

Korporate Classics Corporation (KCC) won a bid to supply widgets to Pacer Corporation but lost money on the deal because they underbid the project. KCC fell victim to _____.

winner's curse

When evaluating cost-cutting proposals, how are operating cash flows affected?

Additional depreciation deduction & decrease in costs increases operating income

Equation for estimating operating cash flows using Tax shield approach

OCF= (Sales-costs) * (1-tax rate) + Depreciation * Tax rate

Opportunity Cost

Requires us to give up a benefit

T/F: A sunk cost is an example of a relevant incremental cash flow.

False

When developing cash flows for capital budgeting, it is _____ to overlook important items.

Easy

First step in estimating cash flow is to determine the _____ cash flows

Relevant

3 main sources of cash flows over the life of a typical project.

Cash outflows from investment in plant and equipment at the inception of the project, net cash flows from sales and expenses over the life of the project, and net cash flows from salvage value at the end of the project.

Investment in NWC arises when _____.

Credit sales are made, inventory is purchased, and cash is kept for unexpected expenditures.

Equation for estimating operating cash flows using the top-down approach

OCF= Sales - Costs - Taxes

Side effects from investing in a project refer to cash flows from:

erosion effects & beneficial spillover effects

Relationship between depreciation, income, taxes and investment cash flows.

As depreciation expense increases, net income and taxes will decrease, while cash flows will increase.

Rules for depreciating assets for tax purposes are based upon provisions in the ______.

1986 Tax Reform Act

Once cash flows have been estimated, which of the following investment criteria can be applied to them?

NPV, Payback period, IRR

Erosion

Negative impact on the cash flows of an existing product from the introduction of a new product.