Chapter 10 !
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 the
winner's curse
consequence to stand-alone principle
will be evaluating the proposed project purely on its own merits, in isolation from any other activities or projects
Erosion will ______ the sales of existing products
reduce
operating cash flows the tax shield approach
(sales - cost) * ( 1 - tax rate) + Depreciation * tax rate
After-tax salvage value
(salvage)-t*(salvage-book)
3. Tax Shield Approach
**most useful on exam and in real life OCF= (after tax profit) (depreciation tax shield) OCF= (Sales-costs)(1-t)+ (Depreciation *t) **only works when theres no interest expense -useful with MACRS (modified accelerated cost recovery system)
Which of the following are considered relevant cash flows?
-Cash flows from opportunity costs -Cash flows from erosion effects -Cash flows from beneficial spillover effects
Identify the 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
Negative Side effects -what is it -cannibalization/erosion
-Costs to other projects (how much will be lost because of this?) -introducing pom oatmeal will cut into sales of existing flavors. the lost revenue from reduced sales of raisin oatmeal should be included as an incremental CF -Introducing a new flavor could just transfer sales, not increase them. But sometimes necessary to keep up with competitors
Once cash flows have been estimated, which of the following investment criteria can be applied to them?
-IRR -payback period -NPV
Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?
-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. -Book value represents the purchase price minus the accumulated depreciation.
When evaluating cost-cutting proposals, how are operating cash flows affected?
-There is an additional depreciation deduction. -The decrease in costs increases operating income.
Depreciation
-a non cash expense, but it affects taxes which are a CF -matching things up over time -an ALLOCATION principle for tangible assets -shows up in income statement as depreciation expense, deduct it before calculating taxes so you save tax money -only care about it as far as it affects taxes
2. Changes in NWC
-cash flows associated with cash on hand to smooth the current accounts -Source: **balance sheet** (current assets, current liabilities) -money you put in that you get back out at the end -will be near 0 over the course of the project -account usually comes at the beginning and end of the project
Net Capital spending (NPS)
-cash flows associated with the fixed assets of the project -large expenditures on plant and equipment infrequently Source: **balance sheet** -used for spending on big ticket items; machiner, etc -usually a massive outflow at first then nothing for a while
common current assets
-cash receivables -inventory
Side effects of opportunity costs
-changes in cash flows of your existing operation -adding a new project might change those cash flows
1. Sunk Costs -what are they? -Incremental
-costs that have accrued in the past, before the project is accepted -Marketing studies, drug companies paying for R&D -NOT incremental: you have to pay for them whether or not you accept the project -Sunk cost fallacy: "we spent all this money, we should do the project"
Investment in net working capital arises when
-credit sales are made -inventory is purchased -cash is kept for unexpected expenditures
straight line vs MACRS
-higher ATSV with MACRS, and TVM (depreciates quicker)
Mid-year convention
-if there is overlap, when you first buy machine you will only get half of the first tax year for tax purposes -if 7 year equipment , theres 8 rates -if 6 year equipment, theres 7 rates
5. Taxes
-if you don't do the project you won't have to pay taxes on it -#2 cost of a firm, can influence whether or not you do a project -**always use AFTER-TAX CASH FLOWS -INCREMENTAL CASH FLOW
As depreciation expense __________, net income and taxes will decrease, while cash flows will __________
-increases -increase
Other things to watch out in investments:
-interested only in measuring cash flow -always interested in after tax cash flow because taxes are definitely cash outflow
common current liabilities
-payables
Pro Forma Statements
-projected accounting statements capital budgeting relies on -use them as a road map for the future of your business project, usually generating them from GAAP -NOT required, generated to control and compare -best prediction of what the project will look like
1. Operating Cash Flow (OCF)
-regularly generated cash flows from the ongoing activities of the project -Source:** Income statements ** (wages, checks to suppliers, insurance, utilities, and resulting cash sales)
4. Financing costs
-should NOT be included in incremental CFs because they are associated with creditors and not assets -direct CFs associated with a project don't change due to how you finance it -Interest and dividends are FC so are NOT incremental CFs
1. Bottom-up approach
-simplest, easiest -bottom item on the income statement is net income -include depreciation because it impacts taxes -**only works when there is no interest expense OCF= NI + depreciation
Cash Flow From Assets (CFFA)
-the total net cash flow per period associated with a project -CFs used on timeline in chapter 9 -includes all incremental cash flows
Incremental Cash flows
-those that change if and only if you do the project -the cash flows that should be included in a capital budgeting analysis are those that only occur if the project is accepted
2. Top-down approach
-top item on an income statement is sales -**equation: NOT using financial accounting standards, but what you will have to take in taxes **only works when theres no interest expense OCF=Sales-costs-taxes
OCF Top down (OCF=S-C-T) Sales and costs on IS reflect changes in sales and costs....
...from beginning to end of a period
Balance sheet decreases...
...inflow
Balance sheet increases...
...outflow
**If adding a new project changes CFs of existing operation...
...those side effects should be taken into account as INCREMENTAL CASH FLOWS
1. Costs 2. to adjust:
1. =Δcash costs+ ΔAP 2.=OCF+ΔAP
1. Revenue 2. to adjust:
1. =Δcash sales+ΔAR 2. OCF- ΔAR
3 methods for computing OCF:
1. Bottom-up approach 2. Top-down approach 3. Tax-Shield Approach
2. Opportunity Costs
1. Incremental Cash Flow 2. You forego something when you accept a project 3. Cost of Lost options
CFFA has 3 components:
1. Operating Cash Flow 2. Changes in NWC 3. Net Capital Spending
What are the common types of Cash flows?
1. Sunk Costs 2. Opportunity Costs 3. Change in net working capital 4. Financing Costs 5. Taxes
The bonus depreciation in 2019 was _____ percent.
100
According to the 2017 Tax Cuts and Jobs Act, bonus depreciation is phased out after
2026
Ending book value
= initial cost - AD =net equipment in last year
ATSV=
=NCS in last period **INFLOW
ATSV= or net flow or Money you get to keep
=Selling price - (tax consequence) =Salvage- t*(salvage - book value)
why do we consider changes in NWC separately?
Accruals -Sales recorded on the IS when made, not when cash received -record COGS when sales are made, not when cash is paid to suppliers -we have to buy inventory to support sales although the cash from selling it comes later put cash in to smooth over current accounts for these reasons --> incremental cash flow
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
NWC=
CA-CL
3. Changes in net working capital -definition -laplante definition
Change in current assets - change in current liabilities -cash you put into a business to "smooth over" current accounts payable, or else you would go out of business -cash used to pay expenses until receivables are collected and sales are made -Usually cash OUTFLOW at beginning of project, and cash INFLOW as the project ends (inflow bc money no longer needed to smooth over current accounts -INCREMENTAL CF!
Depreciation tax shield=
D*t D=depreciation expense t=marginal tax rate also equal to difference in NI with and without depreciation expense ***This is an inflow
Straight-line depreciation
D= (initial cost-ending book value)/number of years of useful life -depreciate same amount each year
Operating cash flows
EBIT + Depreciation - Taxes
Taxes =
EBIT x tax rate
ΔNWC=
End NWC-Beginning NWC
While making capital budgeting decisions, which of the following sentence is true regarding the initial investment of net working capital?
It is expected to be recovered by the end of the project's life.
NCS at time 0
Long term assets Usually under "net equipment" subtract accumulated depreciation from equipment each year to get net equipment only have to subtract at one point in time usually (when it occurs)...OUTFLOW AT TIME 0
Combine above 2 adjustments:
OCF - ΔAR +ΔAP --> OCF-(ΔAR-ΔAP) -->OCF-ΔNWC ****** this is the adjustment for accruals
**at each point in time for a project, CFFA=
OCF-ΔNWC-NCS OCF income statement -ΔNWC balance sheet -NCS balance sheet -------------- CFFA
EBIT
Sales - Costs - Depreciation
Which of the following is an example of a sunk cost
Test marketing expenses
Among the three main sources of cash flow, which source of cash flow is the most important and also the most difficult to forecast?
The operating cash flows from net sales over the life of the project
incremental cash flows for project evaluation consist of
any and all changes in the firms future cash flows that are a direct consequence of taking the project
Will this cash flow occur only if we accept the project?
Yes: it should be included in the analysis because its incremental No: it should not be included in the analysis because it will occur anyway Part of it: include that part that occurs because of the project
skunk cost
a cost that has already been paid and cannot be recovered
Accelerated Cost Recovery System (ACRS)
a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications
NCS in last year=
after-tax salvage value, divide by 1000, then added to CFFA
stand-alone principle
allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
Side effects from investing in a project refer to cash flows from
beneficial spillover effects erosion effects
Opportunity costs are
benefits lost due to taking on a particular project
Positive Side effects (externalities)
benefits to other projects -Running an apple orchard and buying bee hives...you will get more $$ from apple bus bc there are more bees around to pollinate -Network effects: more attractive the more people there are on a social media. -Apple watch: makes other products more attractive because they can be used conveniently together
When an asset is sold, there will be a tax savings if the _____ value exceeds the sales price
book
cash flow
cash inflow - cash outflow or operating cash flow - change in NWC
Operating cash flow =
earnings before interest and taxes + depreciation - taxes
to prepare pro forma financial statements we need:
estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed cost
pro forma financial statements
financial statements projecting future years' operations, easy convenient means of summarizing much of the relevant information for a project
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
when is there a tax effect?
if the salvage value is different from the book value of that asset
An increase in depreciation expense will ____ cash flows from operations.
increase
With cost-cutting proposals, when costs decrease, operating cash flows
increase
What is a relevant cash flow for a project?
is a change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take the project
The computation of equivalent annual costs is useful when comparing projects with unequal
lives
pro formas do not include
long-term liabilities and owners equity
operating cash flow bottom up approach
net income + depreciation
any cash flow that exists regardless of whether or not a project is undertaken is
not relevant
what the stand-alone principle says is that
once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of minifirm with its own future revenues and costs its own assets and own cash flows
total cash flow =
operating cash flow - change in NWC - capital spending
If you are a profitable firm, OCF should be______
positive
project cash flow =
project operating cash flow - project change in networking capital - project capital spending
operating cash flows the top down approach
sales - cost - taxes
The tax saving that results from the depreciation deduction is called the depreciation tax
shield
A calculated NPV of $15,000 means that the project is expected to create a positive value for the firm and _____
should be accepted if there is no capital rationing constraint
stand-alone principle
the assumption that evaluation of a project may be based on the project's incremental cash flows
erosion
the cash flows of a new project that come at the expense of a firms existing projects, in this case cash flows from the new line should be adjusted downward to reflect lost profits on other lines
incremental cash flows
the difference between a firm's future cash flows with a project and those without the project, direct consequence
opportunity cost
the most desirable alternative given up as the result of a decision
equivalent annual cost
the present value of a project's costs calculated on an annual basis
depreciation tax shield
the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate
why are there contra-assest accounts/accruals?
trying to convey useful info of economic activity to external users (owners and lenders). Record the sale even if you don't receive cash right away
BV>SV
you get a tax refund
BV<SV
you have to pay tax on it -settling up -over depreciated
