BUSI 530 Chapter 9

If the cost of input is $1,000,000 this year; if you project inflation to be 3% annually, what would be an appropriate forecast for the cost of that input in year 4?

$1,125,508 Reason: Correct. $1,000,000 × (1 + 0.03)^4 = $1,125,508.

A project generates revenues of $5,000, costs of $3,000, and taxes of $700. What is the project's operating cash flow?

$1,300

A project generates revenues of $5,000, costs of $3,000, and taxes of $700. What is the project's operating cash flow?

$1,300 Reason: Correct. $5,000 − $3,000 − $700 = $1,300.

A project generates a net profit of $1.8 million and a depreciation of $200,000. What is the project's operating cash flow?

$2 million Reason: Operating cash flow = net profit + depreciation = $2 million

Andersen Corp will undertake a project that will produce cash flows of $50,000 in year 1, $60,000 in year 2, $70,000 in year 3, $75,000 in year 4, and $68,000 in year 5, what is the present value of those cash flows if Andersen's required rate of return on the project is 15%?

$211,562.53; 50000/(1.15) + 60000/(1.15)2 + 70000/(1.15)3 + 75000/(1.15)4 + 68000/(1.15)5 = $211,562.53.

At the end of a project, a firm's investment has a salvage value of $4 million. The firm will pay taxes of $0.5 million on the sale of the equipment from the investment. What is the net cash flow to the firm?

$3.5 million. Net cash flow = salvage value − tax on gain = $4 million − $0.5 million = $3.5 million.

A project generates revenues of $1.4 million, cash expenses of $1 million, and taxes of $100,000. What is the operating cash flow?

$300,000 Reason: Operating cash flow = revenues - cash expenses - taxes = $1.4 million - $1 million - $100,000 = $300,000

Smith Industries plans to sell an asset at the end of a 5-year project for $250,000. The book value of the asset at that time will be $125,000. The marginal tax rate is 35%. How much tax will Smith pay on the sale, and what will be its net proceeds (cash inflow)?

$43,750; $206,250 Reason: Correct. Tax = (250,000 − 125,000) × 0.35 = 43,750; Net proceeds = 250,000 − 43,750.

Which of the following are commonly made mistakes that managers make in regard to working capital and forecasting project cash flows?

- forgetting that working capital may change during the life of the project - forgetting about working capital entirely - forgetting that working capital is recovered at the end of the project

The Tax Cuts and Jobs Act allows companies to take bonus depreciation sufficient to write off what percent of investment immediately?

100%

Mutually exclusive investments

2 different choices for the assembly lines that will make the same product, & a restaurant or gas station on the same piece of land.

Bonus depreciation is a temporary provision of the Tax Cuts and Jobs Act. It is scheduled to be phased-out starting in

2023

If NPV is positive, the project should be ______.

Accepted

Payback period tells the time it takes to break even in an _________ sense.

Accounting

How does the timing and the size of cash flows affect the payback method?

An increase in the size of the first cash inflow will decrease the payback method, all else held constant

Weaknesses of Discounted payback period

Arbitrary cutoff date, exclusion of some cash flows, and loss of simplicity as compared to the payback method

Decision making process for accepting and rejecting projects

Capital budgeting

Capital budgeting decision method finds the present value of each cash flow before calculating a payback period

Discounted payback period

Length of time until the sum of the discounted cash flows is equal to the initial investment.

Discounted payback period

Discounted payback period tells the time it takes to break even in an _______or financial sense.

Economic

True or false: Financing costs like interest and principal payments on borrowed funds must be included in the incremental cash flows for the project.

FALSE - Financing costs are not included in a project's incremental cash flows because the investment decision needs to be separated from the financing decision. The project should be treated as if it were all-equity financed when calculating cash flows.

Discounted payback rule has an objective benchmark to use in decision making. True/False

False

Investing more money in a project is a guarantee of greater profits.

False

Profitability index is calculated by dividing the PV of the ______ CF by initial investment.

Future

Most important alternative to NPV is the ____ method.

IRR

Point at which the NPV profile crosses the horizontal axis is the:

IRR

Budgeting methods are most used by the firms in the US and Canada

IRR & NPV

An ______ project does not rely on the acceptance or rejection of another project

Independent

The point at which the NPV profile crosses the horizontal axis is the:

Internal Rate of Return

Which of the following are true regarding the inclusion of working capital in project cash flows?

Investment in working capital may change over the life of the project. Investment in working capital is a cash outflow. Recovery of working capital is a cash inflow. Invested working capital is recovered by the end of the project.

Which of the following is true of a project's terminal cash flow?

It may include the recovery of working capital investment. It may be due to the sale of a project asset. It may be positive or negative. It may be due to final cleanup or recovery costs.

If a project has multiple internal rates of return, which of the following methods should be used?

NPV & MIRR

When cash flows are conventional, NPV is ________ if the discount rate is above the IRR.

Negative

Which of the following will correct the effect of depreciation?

Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (tax rate × deprecation). Operating cash flow = after-tax profit + depreciation. Operating cash flow = net income + depreciation.

Which of the following formulas can be used to ensure that depreciation is not included in a project's operating cash flows?

Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (tax rate × deprecation). Operating cash flow = net income + depreciation. Operating cash flow = after-tax profit + depreciation.

Which of the following formulas can be used to ensure that depreciation is not included in a project's operating cash flows?

Operating cash flow = (revenues − cash expenses) × (1 − tax rate) + (tax rate × depreciation). Operating cash flow = revenues − cash expenses − taxes. Operating cash flow = after-tax profit + depreciation.

Capital budgeting method allows lower management to make smaller, everyday financial decisions effectively.

Payback method

When cash flows are conventional, NPV is ______.

Positive for discount rates below the IRR, equal to zero when the discount rate equals the IRR, and negative for discount rates above the IRR.

In capital budgeting, the net ______ determines the value of a project to the company.

Present Value

The IRR rule can lead to bad decisions when _____ or ______.

Projects are mutually exclusive, cash flows are not conventional.

If NPV is negative, the project should be _______.

Rejected

Which of the following forecasted components of project cash flow should be adjusted directly to change with inflation from year to year?

Revenue Expenses

NPV accounts for the size of the project and eliminates the effects of _______

Scale

The payback period rule ____ a project if it has a payback period that is less than or equal to a particular cutoff date.

Suggests accepting

Point at which the NPV profile crosses the vertical axis is the:

Sum of the cash flows of the project.

Some projects, such as mines, have cash outflows followed by cash inflows, which are then followed by cash outflows, giving the project multiple rates of return.

True

The crossover rate is the rate at which the NPV's of 2 projects are equal.

True

True or false: Project discounted cash flow analysis assumes that cash flows occur at the end of the year even though they are actually spread through the year as sales and expenses actually occur.

True

Two challenges with the IRR approach when comparing 2 mutually exclusive projects are scale and cash flow timing.

True

True or false: Project discounted cash flow analysis assumes that cash flows occur at the end of the year even though they are actually spread through the year as sales and expenses actually occur.

True Reason: Correct. This simplifies our calculations.

IRR is 14%, if required return is 14%, the project's NPV is:

Zero

Which of the following statements about working capital is correct?

a project may have WC outflows early, changing to inflows as WC is recovered

Mutually exclusive investment decisions

a situation in which taking one investment prevents the taking of another.

The cash outflow at the start of a project is termed the initial capital investment, and includes:

any investment in fixed assets required by the project. investments in research and marketing required for the project.

To calculate net present value, you need to discount

cash flows

Which of the items below are the elements that must be included in the calculation of a project's total cash flow?

cash flows from changes in working capital cash flow from capital investments operating cash flow

Weaknesses of the payback method

cash flows received after the payback period are ignored, time value of money principles are ignore, cutoff date is arbitrary

A sunk cost is irreversible; sunk costs

do not affect NPV and should be ignored.

The difference between the nominal discount rate and the real discount rate is

expected inflation

By keeping costs such as interest and principal payments on debt out of project cash flows, you are following a fundamental principle of corporate finance known as the separation of investment and ______ decisions.

financing

IRR continues to be very popular in practice, partly because:

gives a rate of return rather than a dollar value

The present value of all cash flows after the initial investment is divided by the _____to calculate the profitability index.

initial investment

Some examples of indirect effects that could affect incremental cash flows would be

loss of existing store sales by locating a new store too close by release of a product that will generate sales of replacement parts and services in future years cannibalization of existing product sales by introduction of a new product increased sales of an existing product by release of a complementary product

The initial capital investment in a project requires a ______ cash flow. The salvage value from a project involves a ______ cash flow.

negative, positive

Land that is used for a manufacturing facility could also be sold. The ______ cost equals the cash that could be realized from selling the land now instead of using it for the manufacturing facility.

opportunity

Amount of time needed for the cash flows from an investment to pay for its initial cost is the:

payback period

Which of the following statements about nominal versus real cash flows are correct?

real cash flows must be discounted by a real discount rate nominal cash flows must be discounted by a nominal discount rate

According to the basic IRR rule, we should____

reject a project if the IRR is less than the required return.

A project's operating cash flow can be calculated using which of the following equations?

revenues - costs - taxes

The cash flows brought about at the end of a project are called ______ and ______ be included in a project's cash flow forecasts.

terminal cash flows; should

An opportunity cost arises in a project whenever

the project uses an existing asset that could have been sold or put to productive use elsewhere

Cash flows from capital investments + operating cash flows + cash flows from changes in working capital =

total cash flow

3 attributes of NPV are that it:

uses all the cash flows of a project, uses cash flows, & discounts the cash flows properly.

IRR is the discount rate that makes the NPV of a project equal to _______.

zero