Chapter 10: Making Capital Investment Decisions

Operating cash flow is a function of:

-Depreciation -EBIT -Taxes

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

-NPV -IRR -payback period

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

Which of the following are fixed costs?

-cost of equipment -rent on a production facility

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

-erosion effects -beneficial spillover effect

Taxes formula

EBIT * tax rate

EBIT formula

EBIT = sales - costs - depreciation

True or False: Opportunity costs can be ignored when determining the financial feasibility of a project.

False

MACRS

Modified Accelerated Cost Recovery System - a type of depreciation method, typically used by the IRS.

Tax shield approach

OCF = (Sales - Costs)(1 - tax rate) + Depreciation*tax rate

Bottom up approach

OCF = Net income - taxes

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

-there is an additional depreciation deduction -the decrease in costs increases operating income

Operating cash flow equation

Operation cash flow = EBIT + Depreciation - taxes

The bonus depreciation in 2019 will be

100%

Rules for depreciating assets for tax purposes are based upon provisions in the ______.

1986 Tax Reform Act

According to the bottom-up approach, what is the OCF if EBIT is $600, depr. is $1,800 and the tax rate is 21%?

2274 OCF = EBIT + depreciation - taxes taxes = 600*.21 = 126 =600+1800-126

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

378 1800*.21 = 378

Sunk cost

A cost that has already been incurred and that cannot be changed by any decision made now or in the future.

Opportunity cost

Requires us to give up a benefit if particular investment is undertaken. Not cash. Ex: We use a mill we already have in a different project but give up using the mill for something else.

Palmer Cor. is choosing between server X and server Y to replace its current equipment. It has gathered the following information: Server X: Estimated life = 2 years ; NPV = -$143,261 Server Y: Estimated life = 3 years ; NPV = -$203,229 if Palmers required rate of return is 8%, what is the EAC of server X and Server y? A. Server X: -$71,630.50Servery Y: -$67,763.00 B. Server X: -$80,336.36Server Y: -$78,859.66

Server X: -$80,336.36 Server Y: -$78,859.66 The EAC for Server X is :-143261=PMT [1-(1/1.08^2) / .08] PMT = -$80,336.36 The EAC for Server Y is:-203229= PMT [1-(1/1.08^3) / .08] PMT= -$78,859.66

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

Cash flows should always be considered on an ____ basis.

after tax

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

are not

Opportunity costs are ______.

benefits lost due to taking on a particular project

Incremental cash flows come about as a _____ consequence of taking a project under consideration.

direct

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

easy

Sunk costs are costs that ______.

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

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

ignored

An increase in depreciation will ____ cash flows from operations.

increase

While making capital budgeting decisions, which of the following sentences is true regarding the initial investment of net working capital?

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

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

lives

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

net working capital

Project cash flow formula

project cash flow = Project operating cash flow - Project change in net working capital - project capital spending

Erosion will ____ the sales of existing products.

reduce

The first step in estimating cash flows is to determine the ______ cash flows.

relevant

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

Stand alone principal

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 firm's existing projects

Equivalent Annual Cost (EAC)

the present value of a project's cost 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

Which of the following are considered relevant cash flows?

-cash flows from erosion effects -cash flows from opportunity costs -cash flows from beneficial spillover effects

Investment in net working capital arises when ____.

-cash is kept for unexpected expenditures -inventory is purchased -credit sales are made

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

8220 =200000-190636-1144 OCF = Sales - Costs - Taxes

ACRS

Accelerated Cost Recovery System; more depreciation is charged to the earlier years of the life of the asset

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.

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

cash flow equation

cash flow = cash inflow - cash outflow

Operating cash flow OCF

OCF = EBIT + Depreciation - Taxes

Top-down approach

OCF = Sales - Costs - Taxes