FIN 331: CH 10 - Making Capital Investment Decisions

The bonus depreciation in 2019 will be:

100%

The rules for depreciating assets for tax purposes are based upon provisions in the ______

1986 Tax Reform Act

Fixed costs

A cash outflow that will occur regardless of the level of sales. SHOULD NOT be confused with some sort of accounting period charge.

Sunk cost

A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.

Cash flows should always be considered on a(n) ______ basis.

After-tax

Incremental cash flows for a project include:

All the resulting changes in the firm's future cash flows.

What do incremental cash flows for project evaluation consist of?

Any and all changes in the firm's future cash flows that are a direct consequence of taking the project.

What is important to recognize when accounting for erosion?

Any sales lost as a result of launching a new product might be lost anyway because of future competition.

When analyzing a project, sunk costs ______ incremental cash outflows.

Are NOT

Erosion

Cash flows of a new project that come at the expense of a firm's existing projects.

Cash flow =

Cash inflow- Cash outflow

Identify three 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. Net cash flows from salvage value at the end of the project.

What is the first and most important step in projecting cash flows?

Deciding which are cash flows are relevant.

Operating cash flow is a function of:

Depreciation, EBIT, Taxes

Incremental cash flows come about as a(n) ____ consequence of taking a project under consideration.

Direct

Taxes=

EBIT x Tc Tc is corporate tax rate

Operating Cash Flow (OCF)

EBIT+Depreciation-Taxes

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

Easy

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

Erosion effects and beneficial spillover effects.

Pro forma financial statements

Financial statements projecting future years' operations.

Calculating the EAC involves

Finding an unknown payment amount.

Expected economic life

How long we expect the asset to be in service

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

IRR, NPV and payback period

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

Ignored

An increase in depreciation expense will ______ cash flows from operations.

Increase

In analyzing a proposed investment, we will not include....

Interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cash flow generated by the assets of the project.

Investment in net working capital arises when ______.

Inventory is purchased. Credit sales are made. Cash is kept for unexpected expenditures.

While making capital budgeting decisions, which of the following sentence is true regarding the initial investment of NWC?

It is expected to be recovered by the end of the project's life.

An asset's class establishes

Its life for tax purposes.

The computation of equivalent annual costs is useful when comparing projects with unequal __________.

Lives

Most firms will not use ____ _____ until 2023 unless they wish to (taking the bonus depreciation is optional)

MACRS schedule.

Opportunity cost

Most valuable alternative that is given up if a particular investment is undertaken.

Accounts receivable and accounts payable are not an issue with project cash flow estimation unless changes in _______ are overlooked.

NWC

Top Down Approach

OCF = Sales - Costs - Taxes

What is the equation for estimating operating cash flows using the top-down approach?

OCF= Sales-Costs-Taxes

Which one of the following is the equation for estimating operating cash flows using the tax shielf approach?

OCF=(Sales-Costs) x (1-Tax) + Depreciation x Tax Rate

Tax shield Approach

OCF=(sales-costs)(1-T)+depreciation*T

A capital gain occurs:

Only if the market price exceeds the original cost.

Total cash flow=

Operating cash flow - change in NWC - Capital spending

Cash flow from assets has three components:

Operating cash flow, capital spending, changes in NWC. WE MUST ESTIMATE EACH OF THESE

Using your personal savings to invest in your business is considered to have an _____ _____ because you are giving up the use of these funds for other investments or uses, such as vacation or paying off a debt.

Opportunity cost

Bottom Up Approach

Project Net Income= EBIT - Taxes

Project cash flow =

Project Operating Cash Flow - Project Change in NWC - Project Capital Spending

Erosion will ______ the sales of existing products.

Reduce

Only cash flow effect of deducting depreciation

Reduce our taxes...beneficial to us

Opportunity costs are classified as ______ costs in project analysis.

Relevant

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.

EBIT

Sales - Costs - Depreciation

Palmer Corp is choosing between server X and server Y to replace its current equipment. It has gathered the following information: Server X 2 years NPV -$143,261 Server Y 3 years NPV -$203,229 If Palmer's required rate of return is 8%, which server should it choose?

Server X -$-80,336.36 Server Y: -$78,859.66

According to the _______ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm."

Stand-alone

What type of cost should you exclude from analysis?

Sunk cost

Must pay taxes at the ordinary income tax rate on the difference between the sale price and the book value.

TRUE

Aftertax cash flow

Taxes are definitely a cash outflow!

Whenever we have an investment in NWC,

That same investment has to be recovered... The same number needs to appear at some time in the future with the opposite sign.

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

The decrease in costs increased operating income There is an additional depreciation deduction.

Once an asset's tax life is determined:

The depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage. Under certain circumstances, the cost of the asset may be adjusted before computing depreciation. The result is called depreciable basis, and depreciation is calculated using this number instead of the actual cost.

Old joke concerning process of setting the bid price:

The low bidder is whoever makes the biggest mistake. Winner's curse.

Based on the Protecting Americans from Tax Hikes (PATH) Act of 2015,

The size of the bonus in 2017 was 50%. This means that a firm can take a depreciation deduction of 50% of the cost on an eligible asset in the first year and then depreciate the remaining 50% using the MACRS schedules.

Depreciation tax shield

The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

NPV=

Total project cash flow (initial) + year 1/(1+r)+ year 2/(1+r)^2 + year 3/(1+r)^3

If you win, there is a good chance you _________________

Underbid.

What is net working capital?

current assets - current liabilities

Operating cash flow =

earnings before interest and taxes + depreciation - taxes

Sunk costs are costs that ______

have already occurred and are not affected by accepting or rejecting a project

Costs always have

negative signs

Stand-alone Principle

the assumption that evaluation of a project may be based on the project's incremental cash flows

Incremental Cash Flows

the different between a firm's future cash flows with a project and those without the project

At the end of a project's life,

the fixed assets will be worthless.

Equivalent Annual Cost (EAC)

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

Expected salvage value and expected economic life

Are not explicitly considered in the calculation of depreciation.

Modified ACRS Depreciation (MACRS)

Basic idea is that every asset is assigned to a particular class.

Tax Cuts and Jobs Act of 2017

Increased bonus depreciation to 100% for 2018, lasting until the end of 2022. Afterwards, it will drop 20% per year until reaching 0 after 2026.

the first step in estimating cash flow is to determine the _____ cash flows.

Relevant

Which of the following are fixed costs?

Rent on a production facility and cost of equipment

Which of the following correctly describes the relationship between depreciation, income, taxes, and investment cash flows?

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

The issue in evaluating cost-cutting proposals

Whether cost savings are large enough to justify the necessary capital expenditure.

A decision frequently faced in evaluating cost-cutting proposals

Whether to upgrade existing facilities to make them more cost-effective.

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

Accelerated cost recovery system (ACRS)

a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications

According to the bottom-up approach, what is the OCF is EBIT is $600, depreciation is $1800, and the tax rate is 21%?

$2,274

What is the depreciation tax shield if EBIT is $600, depreciation is $1,800, and the tax rate is 21%?

$378

According to the top down approach, what is the OCF is sales are $200,000, total cash costs are $190,636, and the tax bill is $1,144?

$8,220

Which of the following statements regarding the 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 - Taxes are based on the difference between the book value and the sales price. - There will be a tax savings if the book value exceeds the sales price.

For a number of years prior to 2018,

Various tax rules and regulations were enacted that allowed "bonus" depreciation.

Expected salvage value

What we think the asset will be worth when we dispose of it

Erosion is only relevant when

Sales would not otherwise be lost.