Finance Exam 3 Terms

The internal rate of return:

The IRR makes the NPV of the project equal to zero, which means that the PI of the project equal to one.

The next most valuable alternative that is foregone when a particular project undertaken is a (an):

"Opportunity cost" is a common term in economics and finance and refers to the value of the next most highly valued use of a resource.

If the firm's working capital investment increases as a result of accepting a new project, the amount of the increase should be:

An increase in working capital is a reduction in free cash flow. Note that working capital investment usually increases in the early years of a project and is recaptured by the end of the project. In the simple case, an investment in working capital is an outflow at time 0 and the recapture/reduction of working capital is an inflow at the end of the life of the project. There are no tax consequences associated with changes in working capital.

Incremental Cash Flows

Cash flows that arise that are directly related to a specific project and would not occur otherwise.

The net present value of a project is smaller when:

Cash inflows are pushed farther into the future The time value of money means that pushing the inflows farther into the future makes their value smaller today. If the cash inflows are delayed, then the present value of the cash inflows decreases which decreases the NPV. Decreasing the required return (aka discount rate) or the initial outlay will increase the NPV.

Profitability Index

Control (scale) for the initial outlay to give management a sense of return. Takes the present value of all future cash flows and then divide it by the initial outlay.

current expenses

Current expenses are outlays for goods and services that will be used during the current year.

tax effect

Multiply the market value minus the book value of the asset by the tax rate. Tax Effect = (Market Value - Book Value) X Tax Rate

Simplified Straight-line Depreciation

Depreciable Base Amount / Useful Life (no salvage value) Makes the additional assumption that the asset has zero salvage value.

MACRS

Depreciation Expense = cost × percentage Percentage determined by life Cost, or basis, never changes

Capital Budgeting—A Three-Step Process

Evaluate the Cash Flows Assess Project Risk Accept or Reject the Project

Which one of the following items should NOT be included in capital budgeting analysis? The shipping cost of a new machine. The cash from selling old equipment that is replaced when new equipment is acquired. Training costs required to safely operate the new equipment if purchased. The consulting fee associated with a previously completed market analysis.

Expenses related to a previously completed market study are a sunk cost and are not relevant to future incremental cash flows or the current decision.

Internal rate of return is calculated by:

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

Differential Cash Flows

For each year of the project's life, calculate: Incremental Revenue-Incremental Costs-Depreciation on Project=Incremental Earnings before Taxes (EBT)-Tax on Incremental EBT=Incremental Earnings after Taxes (aka NI)+Depreciation Reversal=Annual Cash Flow

Replacement Chain Approach

For two or more projects with unequal lives, this approach equalize the lives of both options by stacking projects to the least-common life period.

Internal Rate of Return (IRR)

IRR is the rate of return (in percentage terms) that the firm earns back on its capital projects/investments.

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

If the company experiences a taxable loss, then it will have a tax shield. We consider the tax shield to be a cash inflow.

Cannibalization

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

examples of oppurtuinity cost,sunk cost,incremental and accidental

Incremental CFs - cash in minus cash out Points to Remember: Incidental CFs - directly and indirectly related Sunk costs - don't matter Opportunity costs - do matte

Net Present Value

Net present value (NPV) is the present value of an investment's expected cash inflows minus the costs of acquiring the investment. the sum of the present value of all the projects expected cash flows

Net Working Capital

Net working capital is defined as current assets minus current liabilities.

Initial Outlay

Purchase Price of the Asset + Shipping and Installation Costs Depreciable Asset + Investment in Working Capital +/- After-Tax Proceeds from Sale of Old Asset = Net Initial Outlay

terminal value

Realizable Salvage Value +/- Tax Effects of Capital Gain/Loss + Recapture of Net Working Capital

Equivalent Annual Annuity (EAA)

The EAA is simply the annuity payment with the same life, discount rate, and present value as the project.

Payback Period

The amount of time it takes for the project to generate enough cash to pay for itself.

Capital budgeting is defined as the process of:

The purpose of capital budgeting is to identify those projects that increase firm value.

Direct Cash Flows

These are cash flows that are obviously and directly created by the project.

Indirect Cash Flows

These cash flows are also created by the project, but are not explicit revenues or costs.

gain

When salvage/market value of an inventory is greater than the book value, the firm assumes a gain. This results in a TAX liability

loss

When salvage/market value of an inventory is less than the book value, the firm assumes a loss. This results in a TAX shield

Which one of the following condition is necessary to use equivalent annual annuity when copmaring multiple projects?

You use EAA when you are comparing projects that are mutually exclusive, have different lives, and can be repeated at the same cash flows.

Sunk Cost

a cost that has already been committed and cannot be recovered

depreciation reversal

adding back depreciation

capital constrained environment

automation projects have to compete with other sites initiatives in order to justify funding. This requires a clear case to be made both financially and to site operations that the project will deliver value above what already exists on site

conventional cash flows

begin with a negative initial outlay followed by a series of positive inflows

A firm is considering replacing a fully-depreciated old plant with a new plant on vacant land the firm already owns. Which of the following should be included in the firm's cash flow projections? The original cost of the vacant land. The price of the vacant land in the current market. The salvage value of the old plant. The depreciation on the new plant. B through D.

bthrough d

Book Value

cost - accumulated depreciation

Salvage Value

expected selling price of an asset at the end of its useful life

All else constant, the net present value of a project increases when:

he required rate of return decreases. The NPV is higher if the required rate is lower. Besides, if more cash flows are generated earlier year and/or if the initial outlay is lower, the NPV of a project becomes higher.

incidental cash flows

is the additional operating cash flows that an organization receives from taking on a new project

Capital Budgeting:

is the process of planning to buy long term assets

Modified Acceleration Cost Recovery System (Marcs)

it is based on a double declining balance system but is operationalized by the tax code

npv pros and cons

its known as the best method, its includes all the capital budgeting requirements: time value of money, all cash flows, and the required return of a project it is very similar to internal rate of return but it is in $ terms instead measure of: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.

payback period pros cons

its subjective it does not include the capital budgeting criteria: the time value of money, the cash flows and the required rate of return its good for a quick evaluation but the managers usually pick the requirement date theres no actual guideline also very simple to calculate

Opportunity Cost

loss of the ability to use that same asset toward the next best project

depreciation expense straight line d

method by which capital expenses are allocated to cost of operations over time the simplest way to work out loss of a value of an asset over time

Capital Rationing

placing restrictions on the amount of new investments or projects undertaken by a company.

un/nonconventional

project which has multiple sign changes in its cash flow stream

capital expenses

represents outlays for items that will provide a benefit to the firm over many years

Exxon is used as an example in the text for what financial concept?

risk characteristics

income tax

tax on earnings from the proposed project its usually a fixed marginal rate

Tax Shield liabaility bill burden

tax savings that result from offsetting positive earnings with negative income taxes on asset sales is that gains, not revenues, are taxed money owed for taxes. amount of tax paid by a person etc.in a specified period considered as a proportion of total income in that period.

standard convention

that working capital (WC) is included in the calculation of initial outflow and is reversed at the end of the project.

Terminal Cash Flow

the after tax cash flow of disposing of or selling the asset, tax impacts from the disposal, and recapture of our net working capital.

Initial Outlay

the immediate cash outflow necessary to purchase the asset and put it in operating order. This includes cost, installation/shipping, and net/working capital, etc.

Differential cash flow

these are the cash flows resulting from the operations of the project each year

irr pros and cons

this method is also known as a good method to use along with the net present value method because it includes all the capital budgeting requirements: time value of money, all the cash flows and the required rate of return. the main difference between the two is the IRR is in % terms con However, IRR is not a good tool when projects must be ranked and some projects do have multiple IRRs.

Which one of the following is NOT a part of working capital? Inventories Accounts payables Accounts receivables Common equity

xcommon equitys