Intro to Finance Chapters 9-10 Exam

What is the task?

It's if we should purchase the product

What are some other ways to calculate Operating Cash Flow (OCF)?

• Bottom-Up Approach - Net Income + Depreciation • Top-Down Approach - Sales - Costs - Taxes • Tax Shield Approach - [(Sales - Costs)(1 - T)] + (Depreciation * T)

How do you calculate Book Value?

Initial Cost - Accumulated Depreciation

How do you calculate After-Tax Salvage?

1.) Salvage - T * (Salvage - Book Value at Time of Sale)

Opportunity Costs

Cost of lost options

Sunk Costs

Costs that have accrued in the past

Operating Cash Flow (OCF)

A measure of the amount of cash generated by a company's normal business operations

Average Accounting Return (AAR)

A measure of the average accounting profit compared to some measure of average accounting value of a project. It is then compared to a required return by the company.

What are the first 5 answers on the exam?

A, B, C, D, C

What is the payback period rule?

An investment is acceptable if its calculated payback period is less than some pre-specified number of years

What is the net present value rule?

An investment should be accepted if the net present value is positive and rejected if it is negative

Stand-Alone (or Independent) Projects

Any set of projects in which choosing one has no impact on our decision to choose another project from that set

Incremental Cash Flows

Are those that will only occur (or not occur) if the project is accepted

How do you compute Average Accounting Return (AAR)?

Average Net Income ------------------------ Average Book Value

Book Value

Based on a company's balance sheet

Market Value

Based on a company's share price

Cash Flow from Assets (CFFA)

Computes the annual cash flows for capital budgeting purposes

How do you calculate Operating Cash Flow (OCF)?

EBIT + Depreciation - Taxes

Discounted Payback Period

How long does it take to get the initial cost back after you bring all of the cash flows to the present value?

Payback Period

How long does it take to get the initial cost back in a nominal sense?

Profitability Index

Measures the benefit per unit cost of a project, based on the time value of money

How do you calculate Cash Flow from Assets (CFFA)?

Operating Cash Flow (OCF) - Net Capital Spending (NCS) - Changes in Net Worth (NW)

How do you compute Profitability Index?

PV of Inflows ----------------- PV of Outflows

What is the payback period?

The amount of time required for an investment to generate cash flows sufficient to recover its initial cost

Equivalent Annual Cost (EAC)

The annual cost of owning, operating, and maintaining an asset over its entire life

Net Working Capital (NWC)

The difference between a business's short-term assets and its short-term debts and liabilities

Net Present Value

The difference between the market value of a project and its cost

Internal Rate of Return (IRR)

The discount rate (or required return) that will bring all of the cash flows into present value time and total the exact value of the cost of the project (it is the return that will yield a NPV = $0)

After-Tax Salvage Value

The price at which a good is sold becomes an income on the statement and therefore, attracts tax

Modified Internal Rate of Return (MIRR)

The reinvestment rate for the cash flows is determined by the evaluator. It's the interest rate that compares the future value of the cash flows with the cost of the project.

What is the goal with projects?

To determine if we will exceed our cost with the cash flows identified

Straight Line Depreciation and MACRS Depreciation

Used to compute the depreciation of an asset

Under what circumstances will the IRR and NPV rules lead to the same accept-reject decisions?

When projects which are being analyzed have conventional cash flows

A project has a net present value of zero. Which one of the following best describes this project? a. the project's cash inflows equal its cash outflows in current dollar terms b. the summation of all of the project's cash flows is zero c. the project requires no initial cash investment d. the project has a zero percent rate of return e. the project has no cash flows

a. the project's cash inflows equal its cash outflows in current dollar terms

A company that utilizes the MACRS system of depreciation but does not use bonus depreciation: a. will have a greater depreciation tax shield in Year 2 than in Year 1 b. will expense less than the entire cost of an asset c. can depreciate the cost of land d. will fully depreciate a MACRS five-year asset within 5 years e. will have equal depreciation costs each year of an asset's life

a. will have a greater depreciation tax shield in Year 2 than in Year 1

The length of time a firm must wait to recoup, in present value terms, the money it has invested in a project is referred to as the: a. net present value period b. discounted payback period c. internal return period d. discounted profitability period e. payback period

b. discounted payback period

Which one of the following methods determines the amount of the change a proposed project will have on the value of a firm? a. payback b. net present value c. internal rate of return d. profitability index e. discounted payback

b. net present value

The present value of an investment's future cash flows divided by the initial cost of the investment is called the: a. net present value b. profitability index c. internal rate of return d. profile period e. average accounting return

b. profitability index

A project has an initial cost of $27,400 and a market value of $32,600. What is the difference between these two values called? a. payback value b. profitability index c. net present value d. internal return e. discounted payback

c. net present value

Why is payback often used as the sole method of analyzing a proposed small project? a. payback is focused on the long-term impact of a project b. all relevant cash flows are included in the payback analysis c. payback is the most desirable of the various financial methods of analysis d. it is the only method where the benefits of the analysis outweigh the costs of the analysis e. payback considers the time value of money

d. it is the only method where the benefits of the analysis outweigh the costs of the analysis

Pro forma financial statements can best be described as financial statements: a. expressed in a foreign currency b. expressed in real dollars, given a stated base year c. where all accounts are expressed as a percentage of last year's values d. showing projected values for future time periods e. where the assets are expressed as a percentage of total assets and costs are expressed as a percentage of sales

d. showing projected values for future time periods

If a project has a net present value equal to zero, then: a. any delay in receiving the projected cash inflows will cause the project to have a positive NPV b. the project's profitability index must be also equal to zero c. a decrease in the project's initial cost will cause the project to have a negative NPV d. the project earns a return exactly equal to the discount rate e. the total of the cash inflows must equal the initial cost of the project

d. the project earns a return exactly equal to the discount rate

Advantages of Profitability Index

• Closely related to NPV, generally leading to identical decisions • Easy to understand and communicate • May be useful when available investments are limited

Advantages of Internal Rate of Return (IRR)

• Considers all of the cash flows in the computation • Uses the time value of money • If it's high enough, you may not need to estimate a required return, which is often a difficult task • Usually provides a similar answer to the NPV computation

Advantages of Net Present Value

• Considers all of the cash flows in the computation • Uses the time value of money • Provides the answer in dollar terms, which is easy to understand • Usually provides a similar answer to the IRR computation

Advantages of Average Accounting Return (AAR)

• Easy to calculate • Needed information will usually be available

Advantages of Payback

• Easy to understand and compute (you just subtract!) • Adjusts for uncertainty of later cash flows • Biased toward liquidity

Disadvantages of Payback

• Ignores the time value of money • Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff date • Biased against long-term projects, such as research and development, and new projects

Advantages of Discounted Payback

• Includes time value of money • Easy to understand • Biased towards liquidity

Disadvantages of Profitability Index

• May lead to incorrect decisions in comparisons of mutually exclusive investments

Disadvantages of Average Accounting Return (AAR)

• Not a true rate of return; time value of money is ignored • Uses an arbitrary benchmark cutoff rate • Based on accounting net income and book values, not cash flows and market values

What are the most commonly used capital budgeting procedures?

• Payback Period (PB) • Internal Rate of Return (IRR) • Net Present Value (NPV)

Disadvantages of Discounted Payback

• Requires an arbitrary cutoff point • Ignores cash flows beyond the cutoff point • Biased against long-term projects, such as R&D (Research & Development) and new products

Disadvantages of Net Present Value

• Requires the use of the time value money, thus a bit more difficult to compute • Projects that differ by orders of magnitude in cost are not obvious in the NPV final figure

Disadvantages of Internal Rate of Return (IRR)

• Uses the firm's required rate of return for comparison purposes • Unusually high numbers can often occur when a significant amount of the project's cash flows occur early in the life of the project