Chapter 9
The rules for depreciating assets for tax purposes are based upon provisions in the:
1986 Tax Reform Act
Cash Flows from Assets
-Operating cash flows (Net Income + Depreciation) -Capital Spending -Change in Net Working Capital Cash Flow from Assets: Operating cash flows - Capital Spending- Change in Net Working Capital
If a new project requires an investment in net working capital when it is launched, then at the end of the project, NWC will be
100% Reversed
What is Scenario Analysis?
Determines the impact on NPV of a set of events relating to a specific scenario.
Uses (Decreases) of Net Working Capital
-Increase in Cash -Increase in Inventory -Increase in Accounts Receivable -Decrease in Accounts Payable
Opportunity costs are classified as ___ costs in project analysis.
Relevant
What is the key question to ask concerning a project that results in a positive NPV?
What is the underlying source of value?
Which of the following are fixed costs?
-Rent on a production facility -Cost of equipment
When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in:
-Scenario Analysis -Asking What-If Questions
A positive NPV exists when the market value of a project exceeds its cost. Which of these two values is the most difficult to establish: Market value or project cost?
Market Value
Which of the following is an example of a sunk cost?
Test marketing expenses
Suppose a project's operating cash flow is $150, the firm anticipates a $30 investment in net working capital and $80 in capital spending. What is the projects' cash flow?
$40 (150-30-80=40)
Which of the following are considered relevant cash flows?
-Cash flows from erosion effects - Cash flows from beneficial spillover effects -Cash flows from opportunity costs
Which of the following are components of project cash flow?
-Change in net working capital -Operating cash flow -Capital spending
Things that should/should not be included from the analysis of a project
-Include: ~Depreciation ~Opportunity cost ~Erosion ~Net Working Capital -Don't Include: ~Financing Expense ~Sunk Cost
Sources (Increases) of Net Working Capital
-Increase in accounts payable -Decrease in cash -Decrease in accounts receivable -Decrease in inventory
Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons:
-It affects a firm's annual tax liability -It determines taxes owed on fixed assets when they are sold -It determines the book value of assets which affects net salvage value
Which of the following are reasons why NPV is considered a superior capital budgeting technique?
-It considers the riskiness of the project -It properly chooses among mutually exclusive projects -It considers all the cash flows -It considers time value of money
What are the two main benefits of performing sensitivity analysis?
-It identifies the variable that has the most effect on NPV -It reduces a false sense of security by giving a range of values for NPV instead of a single value
Once cash flows have been estimated, which of the following investment criteria can be applied to them?
-NPV -IRR -Payback Period
A manager has estimated a positive NPV for a project. What could drive this result?
-Overly Optimistic management -The project is a good investment -The cash flow estimations are inaccurate
Stand-Alone Principle
-Rather than try to calculate all of the cash flows of the firm both with the project and without it, consider the project as a "mini-company" by itself -Make sure that the cash flows include indirect effects but ignores aspects that the project will not impact. -Ignore Sunk costs (costs that has already been incurred or obligate to make it and will not change regarding decision on project --> land) -Opportunity costs should always be included (even if no direct costs) -Side effects (can be positive or negative --> most common is erosion) -Net working capital (includes such as accounts receivable or inventory --> always recover at end) -Omit all Financing costs (cash flows generated by assets of firm can be distributed to shareholders/investors) -Cash flows on an after Tax basis
An option on a real asset rather than a financial asset is known as a:
-Real Option -Managerial Option
Which of the following qualify as "managerial options"?
-The option to wait -The option to abandon -The option to expand
Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?
-There will be a tax savings if the book value exceeds the sales price -Taxes are based on the difference between the book value and the sales price -Book value represents the purchase price minus the accumulated depreciation
Capital Rationing
-What if the firm has more positive NPV projects than it can afford to invest in? -Will use the total investment and NPV's of options to compare -Increase total investment is the goal
Contingency Planning and Real Options
-When working with estimates, there is always room for error -When we start to get actual results, we can adapt ~Option to expand ~Option to shutdown (permanent or temporary) ~Option to delay (collect more information to make a better decision) -Post project audits -Identifying biases in proposals ~Overestimating to make a project more likely to be accepted ~Underestimating to make realized performance more striking (if bonuses are attached)
The first step in estimating cash flow is to determine the ___ cash flows.
Relevant
What is the difference between scenario analysis and sensitivity analysis?
Scenario analysis considers a combination of factors for each scenario while sensitivity analysis focuses on only one variable at a time.
To Investigate the impact on NPV of a change in one variable, you would employ ___.
Sensitivity Analysis
Financing Expense
The company borrowed $500,000 at an interest rate of 10% to pursue the project
Opportunity Cost
The company can sell land it currently owns or build a new factory
Depreciation
The equipment will be depreciated straight-line over the next 5 years
Straight Line Depreciation
(Original cost-est salvage value) / Usable life -Usually 0 is used for estimated salvage value = causes depreciation expense higher but taxes lower -Sell asset at end --> pay a little more taxes at the end -Gives accountant a little more flexibility, which is why IRS moved to MACRS
Investment in net working capital arises when ___.
- Inventory is purchased -Credit sales are made -Cash is kept for unexpected expenditures
The goals of risk analysis in capital budgeting include:
-Assessing the degree of financing risk -Identifying critical components
Cash flows used in project estimation should always reflect:
-Cash flows when they occur -After-tax cash flows
Operating Cash Flow is a function of:
-Earnings Before Interest and Taxes -Depreciation -Taxes
Side effects from investing in a project refer to cash flows from:
-Erosion effects -Beneficial spillover effects
What-If Analysis (Risks involved)
-Estimation error -Start with base case -Scenario Analysis ~allow all inputs to change in a systematic way ~Best case (optimistic) and worst case (pessimistic) ~Gives a range of possible results -Sensitivity Analysis ~Change only one input at a time ~Which inputs are especially important and which ones we need a good estimate for. -Simulation Analysis ~MOST INTENSIVE ~Change all inputs but in a random manner (correlations are okay) ~ Provides a distribution of results ~ Can be used to gauge likelihood of outcomes
What are the two main drawbacks of sensitivity analysis?
-It does not consider interaction among variables -It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive.
What is an important drawback of traditional NPV analysis?
-It ignores managerial options in investment decisions
Relevant Cash Flows
-Need incremental cash flows -How will this project affect the cash flows of the firm as a whole? -what will cash flows look like with the project vs. without the project
Identify the three main sources of cash flows over the life of a typical project.
-Net Cash Flows from sales and expenses over the life of the project -Net Cash Flows from salvage value at the end of the project -Cash outflows from investment in plant and equipment at the inception of the project
Erosion
As a result of the project, sales on the existing air conditioners will decline by 10%
A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:
Cannot be observed
Incremental cash flows come about as a ___ consequence of taking a project under consideration.
Direct
The difference between a firm's current assets and its current liabilities is known as the ___.
Net Working Capital
What is the total number of inputs that change while doing sensitivity analysis?
One
Erosion will ___ the sales of existing products.
Reduce
One of the most important steps in estimating cash flow is to determine the ___ cash flows.
Relevant
West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ___ of the cash flow estimates.
Reliability
Which of the following is an example of an opportunity cost?
Rental Income likely to be lost by using a vacant building for an upcoming project.
Capital rationing exists when a company has identified positive NPV Projects but can't (or won't) find:
The Necessary Financing
Sunk Cost
The company spent $10 million in research and development costs on the new product
Net Working Capital
The company will invest in inventory before the project is started
In order to analyze the risk of a project's NPV estimate, we should establish ___ for each important estimate variable.
Upper and lower bounds
The basic approach to evaluating cash flow and NPV estimates involves asking:
What-If Questions
The possibility that errors in projected cash flows will lead to incorrect decisions is known as:
-Estimation risk -Forecasting risk
Which of the following is true relative to capital rationing?
-Hard rationing implies the firm is unable to raise funds for projects -Soft Rationing is typically internal in that the firm allocates funds to divisions for capital projects.
Selling Fixed Assets
-If we sell an asset for more than its book value, the IRS requires that the firm pay taxes on the gain -If we sell an asset for less than its book value, the IRS allows the loss to be used as a tax shield (After tax salvage value will be higher than the selling price) -In addition to the selling price, we need to know the book value of the asset at the time of the sale -Ending Book Value should equal zero at the very end
3 Types of Cash Flows dealing with Timing
1) Cash flows that occur at the beginning of the project (net investment) - Investment in fixed assets - Investment in net working capital -No sales or cost 2) Cash flows that occur throughout the project - Operating cash flows -Sales and costs 3) Cash flows that occur at the end of the project (terminal cash flows) - Recovery of net working capital -Sale of fixed assets
Four main steps to Capital Budgeting:
1) Estimate cash flows 2) Apply decision criteria (NPV, IRR, etc) 3) Perform sensitivity analysis (get an idea if we are making the right decision) 4) Conduct post-project review and audit (compare expectations to what actually occurred)
Cash flow should always be considered on an ___ basis.
After-tax
MACRS Depreciation
MARCSt x original depreciable basis -All cars under Class 5 -No salvage value or length of life -3 year class = 4 years of rates -5 year class = 6 years of rates -Year 1 and last year only represent half of a year -Ending book value should be zero
The primary risk in estimation errors is the potential to ___.
Make incorrect capital budgeting decisions
Cash Flows Example Your firm expects to sell 50,000 cans of shark attractant at $4 per can for three years. The fixed costs of production are $12,000 per year and variable costs are $2.50 to produce. The firm will need to invest $90,000 in equipment and another $20,000 in net working capital. The firm's tax rate is 34% and the required return is 20%.
Capital Spending Year 0 = $90,000 Net Working Capital Year 0 = $20,000 Sales: (50,000x4)=200,000 Variable costs (50,000x2.50) = 125,000 Fixed Cost: $12,000 Depreciation: (90,000/3) = $30,000 Taxable Income: (200,000-167,000) = $33,000 End of Year 3: Project recovers $20,000 from beginning net working capital Year 1 cash flow: 51,780 Year 2 Cash flow: 51,780 Year 3 Cash Flow: 71,780 NPV: -110,000 + (51,780/(1.20^1)) + (51,780/(1.20^2)) + (71,780/(1.20^3)) = $10,648 Project should be accepted because it increases profit of firm
Interest expenses incurred on debt financing are ___ when computing cash flows from a project.
Ignored
An increase in depreciation expense will ___ cash flows from operations.
Increase
The stand-alone principle assumes that evaluation of a project may be based on the project's ___ cash flows.
Incremental
The difference between a firm's cash flows with a project versus without the project is called ___.
Incremental Cash Flows
In the context of capital budgeting, what does sensitivity analysis do?
It examines how sensitive a particular NPV calculation is to changes in underlying assumptions