fin exam 3

stand- along principle

used to identify incremental cash flows

what does MACRS need?

needs to know which asset class is appropriate for tax purposes

Degree of Operating Leverage (DOL)

-The higher the DOL, the greater the variability in operating cash flow. -The higher the fixed costs, the higher the DOL. -DOL depends on the sales level you are starting from.

three types of break even analysis

1. accounting break even 2. cash break-even 3. financial break even

% change in OCF=

= DOL * %change in Q

Book Value

=initial cost - accumulated depreciation

after-tax salvage formula

=salvage - T x (salvage-book value)

four ways to compute OCF

Approach 1: OCF = EBIT + Depreciation - Taxes Approach 2: top-down approach OCF = Sales - Costs - Taxes Works only when there is no interest expense Approach 3: Bottom-up approach OCF = Net income + Depreciation Approach 4: Tax-Shield approach OCF = (Sales - Costs) (1-T) + T (Depreciation)

which approach to compute OCF is the most important

Approach 4

A firm's managers realize they cannot monitor all aspects of their projects but do want to maintain a constant focus on the key aspect of each project in an attempt to maximize their firm's value. Given this specific desire, which type of analysis should they require for each project and why? A) Sensitivity analysis; to identify the key variable that affects a project's profitability B) Scenario analysis; to guarantee each project will be profitable C) Cash breakeven; to ensure the firm recoups its initial investment D) Accounting breakeven; to ensure each project earns its required rate of return

A) Sensitivity analysis; to identify the key variable that affects a project's profitability

The change in revenue that occurs when one more unit of output is sold is referred to as: A) marginal revenue B) average revenue. C) total revenue. D) erosion. E) scenario revenue.

A) marginal revenue.

The difference between a company's future cash flows if it accepts a project and the company's future cash flows if it does not accept the project is referred to as the project's: A) incremental cash flows. B) internal cash flows. C) external cash flows. D) erosion effects.

A.) incremental cash flows

Which one of the following is the relationship between the percentage change in operating cash flow and the percentage change in quantity sold? A) Degree of sensitivity B) Degree of operating leverage C) Accounting break-even D) Cash break-even E) Contribution margin

B) Degree of operating leverage

When the present value of the cash inflows exceeds the initial cost of a project, then the project should be: A) accepted because the payback period is less than the required time period. B) accepted because the profitability index is greater than 1. C) accepted because the profitability index is negative. D) rejected because the internal rate of return is negative. E) rejected because the net present value is positive.

B) accepted because the profitability index is greater than 1.

Which one of the following is an example of a sunk cost? A) $1,500 of lost sales because an item was out of stock B) $1,200 paid to repair a machine last year C) $20,000 project that must be forfeited if another project is accepted D) $4,500 reduction in current shoe sales if a store commences selling sandals

B.) $1,200 paid to repair a machine last year

The degree of operating leverage is equal to: A) 1 + OCF/(FC + VC). B) 1 + OCF/FC. C) 1 + FC/OCF. D) 1 + VC/OCF. E) 1 − (FC + VC)/OCF.

C) 1 + FC/OCF.

Which one of the following would make a mutually exclusive project unacceptable? A) Cash inflow for net working capital at Time 0 B) Requiring fixed assets that would have no salvage value C) An equivalent annual cost that exceeds that of an alternative project D) Lack of revenue generation E) A depreciation tax shield that exceeds the value of the interest expense

C) An equivalent annual cost that exceeds that of an alternative project D) Lack of revenue generation

Forecasting risk is defined as the possibility that: A) some proposed projects will be rejected. B) some proposed projects will be temporarily delayed. C) incorrect decisions will be made due to erroneous cash flow projections.

C) incorrect decisions will be made due to erroneous cash flow projections.

EAC decision rule

Choose the one with the lowest EAC

A project has a unit price of $29.99, a variable cost per unit of $9.06, fixed costs of $487,020, and depreciation expense of $38,009. Ignore taxes. What is the accounting break-even quantity? A) 28,269 units B) 24,584 units C) 29,306 units D) 25,085 units

D) 25,085 units Q = ($487,020 + 38,009)/($29.99 − 9.06) = 25,085 units

Which one of the following represents the level of output where a project produces a rate of return just equal to its requirement? A) Capital break-even B) Cash break-even C) Accounting break-even D) Financial break-even E) Internal break-even

D) Financial break-even

By definition, which one of the following must equal zero at the accounting break-even point? A) Net present value B) Depreciation C) Contribution margin D) Net income E) Operating cash flow

D) Net income

The depreciation tax shield is best defined as the: A) amount of tax that is saved when an asset is purchased. B) tax that is avoided when an asset is sold as salvage. C) amount of tax that is due when an asset is sold. D) amount of tax that is saved because of the depreciation expense. E) amount by which the aftertax depreciation expense lowers net income.

D) amount of tax that is saved because of the depreciation expense.

Uptown Promotions has three divisions. As part of the planning process, the CFO requested that each division submit its capital budgeting proposals for next year. These proposals represent positive net present value projects that fall within the long-range plans of the firm. The requests from the divisions are $4.2 million, $3.1 million, and $6.8 million. For the firm as a whole, management has limited spending to $10 million for new projects next year even though the firm could afford additional investments. This is an example of: A) scenario analysis. B) sensitivity analysis. C) an operating leverage application. D) soft rationing. E) hard rationing.

D) soft rationing.

When you assign the highest anticipated sales price and the lowest anticipated costs to a project, you are analyzing the project under the condition known as: A) best-case sensitivity analysis. B) worst-case sensitivity analysis. C) best-case scenario analysis. D) worst-case scenario analysis.

D) worst-case scenario analysis.

When you assign the lowest anticipated sales price and the highest anticipated costs to a project, you are analyzing the project under the condition known as: A) best-case sensitivity analysis. B) worst-case sensitivity analysis. C) best-case scenario analysis. D) worst-case scenario analysis. E) base-case scenario analysis.

D) worst-case scenario analysis.

You are in charge of a project that has a degree of operating leverage of 1.06. What will happen to the operating cash flows if the number of units you sell increase by 3.7 percent? A) 3.49 percent decrease B) 4.76 percent decrease C) 3.70 percent decrease D) 3.92 percent increase

D.) 3.92% increase %ΔOCF = 1.06 (3.7%) %ΔOCF = 3.92% increase

PC Enterprises wants to commence a new project but is unable to obtain the financing under any circumstances. This firm is facing: A) financial deferral. B) financial allocation. C) capital allocation. D) hard rationing.

D.) hard rationing

Which type of analysis identifies the variable, or variables, that are most critical to the success of a particular project? A) Scenario B) Simulation C) Break-even D) Sensitivity

D.) sensitivity

Simulation analysis is based on assigning a ________ and analyzing the results. A) narrow range of values to a single variable B) narrow range of values to multiple variables simultaneously C) wide range of values to a single variable D) wide range of values to multiple variables simultaneously

D.) wide range of values to multiple variables simultaneously

straight line depreciation

D= (initial cost- salvage) / # of years

DOL formula

DOL= 1+ (FC/OCF) Where DOL (Degree of operating leverage) is a "multiplier" which measures the effect of a change in quantity sold on OCF.

Assume both the discount and tax rates are positive values. At the financial break-even point, the: A) payback period equals the project's life. B) NPV is negative. C) OCF is zero. D) contribution margin per unit equals the fixed costs per unit. E) IRR equals the required return.

E) IRR equals the required return.

By definition, which one of the following must equal zero at the cash break-even point? A) Net present value B) Internal rate of returnC ) Contribution margin D) Net income E) Operating cash flow

E) Operating cash flow

Steve is fairly cautious when analyzing a new project and thus he projects the most optimistic, the most realistic, and the most pessimistic outcome that can reasonably be expected. Which type of analysis is he using? A) Simulation testing B) Sensitivity analysis C) Break-even analysis D) Rationing analysis E) Scenario analysis

E) Scenario analysis

EAC formula

EAC = NPV / Annuity factor Annuity factor = ( 1 - 1/ (1+ r)t) / r

"Base Case" Estimation

Estimated NPV based on initial cash flow projections

MACRS stands for...

Modified Accelerated Cost Recovery System

MACRS Formula

Multiply percentage given in table by the initial cost... depreciate to zero

Simulation Analysis

a combination of scenario and sensitivity analysis (changes multiple variables simultaneously)

capital rationing occurs when...

a firm or division has limited resources. - more good projects than money

depreciation

a non-cash expense

pro-forma statement

an analysis used to... summarize relevant info about the project

Scenario Analysis

considers different scenario results

hard rationing

capital will never be available for this project -Financial distress -Pre-existing contractual agreement

Sensitivity Analysis

changes one variable

break-even analysis

decides the quantity that should be sold

forecasting risk

how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk.

After-Tax Salvage

if the salvage value is different than the book value of the asset, there is a tax effect

The operating cash flow for a project should exclude which one of the following? A) Taxes B) Variable costs C) Fixed costs D) Interest expense E) Depreciation tax shield

interest expense

why is depreciation relevant?

is affects taxes

when there is forecasting risk....

it is possible that incorrect decisions will be made due to erroneous cash flow projections

captal budgeting relies heavily on...

pro-forma accounting statements, particularly income statements

Accounting Break-Even Analysis

sales volume at which NI=0 Q= (FC+ D) / (P-V)

Financial Break- Even Analysis

sales volume at which NPV=0

Cash Break-Even Analysis

sales volume at which OCF=0

incremental cash flows

those that will only occur (or not occur) if the project is accepted. They should be included in a capital budgeting analysis.

*if it appreciates to zero....

than the book value= 0

The bottom-up approach to computing the operating cash flow applies only when: A) both the depreciation expense and the interest expense are equal to zero. B) the interest expense is equal to zero. C) the project is a cost-cutting project. D) no fixed assets are required for a project. E) both taxes and the interest expense are equal to zero.

the interest expense is equal to zero.

soft rationing

the limited resources are temporary, often self- imposed

EAC

the present value of the project's cost calculated on an annual basis

operating leverage

the relationship between sales and operating cash flow