Fin 311 Chapter 10

The _______ curse says that the lowest bidder is the one who underbid the most.

winner's

True or false: When developing cash flows for capital budgeting, it is easy to overlook important items.

True

With cost-cutting proposals, when costs decrease, operating cash flows _____ (decrease/increase).

increase

As a practical matter, it is easier to ______ (decrease/increase) operating leverage than it is to ______ (decrease/increase) it.

increase decrease

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

When analyzing a proposed investment, we _______ (will/won't) include interest paid or any other financing costs.

won't

You own a house that you rent for $1,175 per month. The maintenance expenses on the house average $215 per month. The house cost $222,000 when you purchased it 4 years ago. A recent appraisal on the house valued it at $244,000. If you sell the house you will incur $19,520 in real estate fees. The annual property taxes are $2,650. You are deciding whether to sell the house or convert it for your own use as a professional office. What value should you place on this house when analyzing the option of using it as a professional office? a) $224,480 b) $0 c) $222,000 d) $220,440 e) $244,000

a) $224,480 Opportunity cost = $244,000 − 19,520 Opportunity cost = $224,480

True or false: Cash flows should always be considered on an aftertax basis

True

Incremental cash flows come about as a(n) ________ consequence of taking a project under consideration. a) sporadic b) direct c) indirect

b) direct

Consider an asset that costs $745,000 and is depreciated straight-line to zero over its eight-year tax life. The asset is to be used in a five-year project; at the end of the project, the asset can be sold for $135,000. If the relevant tax rate is 21 percent, what is the aftertax cash flow from the sale of this asset?

The asset has an eight-year useful life and we want to find the BV of the asset after five years. With straight-line depreciation, the depreciation each year will be: Annual depreciation = $745,000/8 Annual depreciation = $93,125 So, after five years, the accumulated depreciation will be: Accumulated depreciation = 5($93,125) Accumulated depreciation = $465,625 The book value at the end of Year 5 is thus: BV5 = $745,000 − 465,625 BV5 = $279,375 The asset is sold at a loss to book value, so the depreciation tax shield of the loss is recaptured. Aftertax salvage value = $135,000 + ($279,375 − 135,000)(.21) Aftertax salvage value = $165,319 To find the taxes on salvage value, remember to use the equation: Taxes on salvage value = (BV − MV)TC This equation will always give the correct sign for a tax inflow (refund) or outflow (payment).

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. The tax rate is 21 percent and the required return on the project is 12 percent. What is the project's NPV?

Using the tax shield approach to calculating OCF (remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use), we get: OCF = (Sales − Costs)(1 − TC) + TC(Depreciation) OCF = ($1,645,000 − 610,000)(1 − .21) + .21($2,180,000/3) OCF = $970,250 Since we have the OCF, we can find the NPV as the initial cash outlay plus the PV of the OCFs, which are an annuity, so the NPV is: NPV = -$2,180,000 + $970,250(PVIFA12%,3) NPV = $150,376.79

A proposed new investment has projected sales of $515,000. Variable costs are 36 percent of sales, and fixed costs are $173,000; depreciation is $46,000. Prepare a pro forma income statement assuming a tax rate of 21 percent. What is the projected net income?

We need to construct a basic income statement. The income statement is: Sales $ 515,000 Variable costs 185,400 Fixed costs 173,000 Depreciation 46,000 ____________________________________ EBT $ 110,600 Taxes (21%) 23,226 ____________________________________ Net income $ 87,374 ----------------------------

Straight-line depreciation

- Depreciation = (Initial cost - salvage) / number of years - Very few assets are depreciated straight-line for tax purposes

Once cash flows have been estimated, which of the following investment criteria can be applied to them? - NPV - the constant growth dividend discount model - YTM - IRR - payback period

- NPV - IRR - payback period

Investment in net working capital arises when ___. - inventory is purchased - equipment is purchased using long term debt - credit sales are made - cash is kept for unexpected expenditure

- inventory is purchased - credit sales are made - cash is kept for unexpected expenditures Reason(s) why it's not the other options: Equipment is categorized as a fixed asset; neither current assets nor current liabilities are affected by the purchase of equipment

Which of the following are fixed costs? - rent on a production facility - cost of equipment - inventory costs - net working capital

- rent on a production facility - cost of equipment Reason(s) why it's not the other options: The other options vary with revenues

MACRS

- Need to know which asset class is appropriate for tax purposes - Multiply percentage given in table by the initial cost - Depreciate to zero

What is net working capital? a) Current assets plus current liabilities b) Current assets minus current liabilities c) Current liabilities minus current assets d) Total assets minus total liabilities

b) Current assets minus current liabilities

While making capital budgeting decisions, which of the following sentence is true regarding the initial investment of net working capital? a) It is treated as cash outflow at the end of the project's life b) It is treated as sunk cost which will not recovered c) It is expected to be recovered by the end of the project's life d) It is not at all considered while making capital budgeting decisions

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

The first step in estimating cash flow is to determine the _________ cash flows. a) operating b) specious c) relevant

c) relevant

The difference between a firm's current assets and its current liabilities is known as the _____. a) long-term capital b) net opportunity capital c) capital structure d) net working capital

d) net working capital Reason(s) why it's not the other options: a) The difference between a firm's current assets and its current liabilities is known as the net working capital, which is short term by its nature. b) he difference between a firm's current assets and its current liabilities is known as the net working capital. c) The difference between a firm's current assets and its current liabilities is known as the net working capital. Capital structure is the way in which assets are financed on the right hand side of the balance sheet.

Fill in the missing numbers for the following income statement. Sales $ 704,600 Costs 527,300 Depreciation 82,100 EBIT Taxes (22%) Net income a) Calculate the OCF. b) What is the depreciation tax shield?

Sales $ 704,600 Costs 527,300 Depreciation 82,100 EBIT $ 95,200 Taxes (22%) 20,944 Net income $ 74,256 a) The OCF for the company is: OCF = EBIT + Depreciation − Taxes OCF = $95,200 + 82,100 − 20,944 OCF = $156,356 b) The depreciation tax shield is the depreciation times the tax rate, so: Depreciation tax shield = TC(Depreciation) Depreciation tax shield = .22($82,100) Depreciation tax shield = $18,062 The depreciation tax shield shows us the increase in OCF by being able to expense depreciation.

An increase in depreciation expense will ____ cash flows from operations. a) increase b) not affect c) decrease

a) increase Reason(s) why it's not the other options: An increase in depreciation expense will increase cash flows because it will decrease taxes paid

Which one of the following is a project cash inflow? Ignore any tax effects. a) Decrease in accounts payable b) Increase in accounts receivable c) Decrease in inventory d) Depreciation expense e) Equipment acquisition

c) Decrease in inventory

Accounts receivable and accounts payable are not an issue with project cash flow estimation unless changes in ______________ are overlooked. a) the cost of capital b) investor sentiment c) tax rates d) net working capital

d) net working capital

According to the _________ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a "minifirm." a) walk-alone b) stand-with c) stand-and-deliver d) stand-alone

d) stand-alone

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. If the tax rate is 21 percent, what is the OCF for this project?

Using the tax shield approach to calculating OCF (remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use), we get: OCF = (Sales − Costs)(1 − TC) + TC(Depreciation) OCF = ($1,645,000 − 610,000)(1 − .21) + .21($2,180,000/3) OCF = $970,250

Which one of the following is an example of a sunk cost? a) $2,000 in lost sales because an item was out of stock b) $2,000 paid last year to rent equipment c) $2,000 project that must be forfeited if another project is accepted d) $2,000 reduction in Product A revenue if a firm commences selling Product B e) $2,000 increase in comic book sales if a store ceases selling puzzles

b) $2000 paid last year to rent equipment

Interest expenses incurred on debt financing are ______ when computing cash flows from a project. a) spread over the life of the project b) treated as cash outflows c) ignored d) treated as cash inflows

c) ignored Reason(s) why it's not the other options: When estimating cash flows from a project, we are only concerned with flows that result from the assets of the project. How we paid for those assets is not relevant

When evaluating cost-cutting proposals, how are operating cash flows affected? - The decrease in costs decreases operating income - The decrease in costs increases operating income - Wages are always reduced in cost-cutting endeavors - There is an additional depreciation deduction

- The decrease in costs increases operating income - There is an additional depreciation deduction Reason(s) why it's not the other options: - A decrease in costs would increase net income - Wages are not always reduced when costs are cut

When a firm finances new investments, it may set up accounts payable with suppliers, but the balance that the firm must supply is called the investment in net _______ capital.

working

Which of the following is an example of a sunk cost? a) Test marketing expenses b) Salvage value of equipment c) Bonus to top management d) Cost of new equipment

a) Test marketing expenses Reason(s) why it's not the other options: b) The salvage value of the equipment will only be received if the project is accepted; therefore it is not a sunk cost. c) The bonus to top management is only paid if it is a function of the project and the project is accepted, and therefore its cost is not a sunk cost. d) The equipment will not be purchased if the project is rejected, and therefore its cost is not a sunk cost.

A calculated NPV of $15,000 means that the project is expected to create a positive value for the firm and _____. a) should be accepted if there is no capital rationing constraint b) it will never cost the firm more than calculated in the cash flow analysis c) the firm should only accepted if the project has a high payback period

a) should be accepted if there is no capital rationing constraint

Bubbly Waters currently sells 420 Class A spas, 570 Class C spas, and 320 deluxe model spas each year. The firm is considering adding a mid-class spa and expects that if it does, it can sell 495 units per year. However, if the new spa is added, Class A sales are expected to decline to 285 units while the Class C sales are expected to increase to 595. The sales of the deluxe model will not be affected. Class A spas sell for an average of $14,300 each. Class C spas are priced at $7,200 and the deluxe models sell for $18,200 each. The new mid-range spa will sell for $9,200. What annual sales figure should you use in your analysis? a) $6,304,500 b) $4,554,000 c) $2,803,500 d) $1,750,500 e) $6,664,500

c) $2,803,500 Sales = 495($9,200) + (285 − 420)($14,300) + (595 − 570)($7,200) Sales = $2,803,500

Power Manufacturing has equipment that it purchased 7 years ago for $2,550,000. The equipment was used for a project that was intended to last for 9 years. However, due to low demand, the project is being shut down. The equipment was depreciated using the straight-line method and can be sold for $400,000 today. The company's tax rate is 21 percent. What is the aftertax salvage value of the equipment? a) $433,333 b) $560,000 c) $435,000 d) $333,333 e) $400,000

c) $435,000 Annual depreciation = $2,550,000/9 Annual depreciation = $283,333 Book value = $2,550,000 − 7($283,333) Book value = $566,667 Tax refund (due) = ($566,667 − 400,000)(.21) Tax refund (due) = $35,000 Aftertax salvage value = $400,000 + 35,000 Aftertax salvage value = $435,000

Erosion will ______ the sales of existing products. a) not affect b) increase c) reduce

c) reduce Reason(s) why it's not the other options: Erosion will reduce the sales of existing products, resulting in reduction in the cash inflow attributable to the new product.

The computation of equivalent annual costs is useful when comparing projects with _____ lives. a) two-year b) equal c) unequal d) infinite

c) unequal

Outdoor Sports is considering adding a putt-putt golf course to its facility. The course would cost $179,000, would be depreciated on a straight-line basis over its 4-year life, and would have a zero salvage value. The sales would be $93,500 a year, with variable costs of $28,350 and fixed costs of $12,950. In addition, the firm anticipates an additional $22,900 in revenue from its existing facilities if the putt putt course is added. The project will require $3,550 of net working capital, which is recoverable at the end of the project. What is the net present value of this project at a discount rate of 11 percent and a tax rate of 21 percent? a) $24,318 b) $65,195 c) $21,980 d) $33,009 e) $26,122

d) $33,009 OCF = ($93,500 + 22,900 − 28,350 − 12,950)(1 − .21) + .21($179,000/4) OCF = $68,727 NPV = −$179,000 − 3,550 + $68,727(PVIFA11%, 4) + $3,550/1.114 NPV = $33,009

The rules for depreciating assets for tax purposes are based upon provisions in the ___. a) 1986 IRS Act b) 1986 Tax Reform Act c) 1986 Sarbanes-Oxley Act d) 1986 SEC Act

b) 1986 Tax Reform Act Reason(s) why it's not the other options: a) The 1986 Act that reformed taxes is called the 1986 Tax Reform Act c) The 2002 Sarbanes-Oxley Act does not deal with depreciation of assets but investor protection from corporate abuses d) The 1986 SEC Act doesn't exist

Opportunity costs are ____. a) benefits gained as a result of accepting a particular project b) benefits lost due to taking on a particular project c) the costs of pursuing a specific project d) the costs incurred by a firm to preserve its market share

b) benefits lost due to taking on a particular project Reason(s) why it's not the other options: a) Opportunity costs are benefits lost by accepting a project c) Opportunity costs are benefits lost, rather than direct costs d) Opportunity costs are not cash flows; rather they are the foregoing of cash flows.

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset qualifies for 100 percent bonus depreciation in the first year. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. The project requires an initial investment in net working capital of $250,000, and the fixed asset will have a market value of $180,000 at the end of the project. The tax rate is 21 percent. a) What is the project's Year 0 net cash flow? Year 1? Year 2? Year 3? b) If the required return is 12 percent, what is the project's NPV?

a) Year 0 cash flow $ -2,430,000 a) Year 1 cash flow $ 1,275,450 a) Year 2 cash flow $ 817,650 a) Year 3 cash flow $ 1,209,850 b) NPV $ 221,767.55 The book value of the equipment at the end of three years is zero, so the aftertax salvage value is: Aftertax salvage value = $180,000 + ($0 − 180,000)(.21) Aftertax salvage value = $142,200 To calculate the OCF, we will use the tax shield approach, so the cash flow each year is: OCF = (Sales − Costs)(1 − TC) + TC(Depreciation) Year 0 = −$2,180,000 − 250,000 = −$2,430,000 Year 1 = ($1,645,000 − 610,000)(.79) + .21($2,180,000) = $1,275,450 Year 2 = ($1,645,000 − 610,000)(.79) = $817,650 Year 3 = ($1,645,000 − 610,000)(.79) + $142,200 + 250,000 = $1,209,850 Remember to include the NWC cost in Year 0, and the recovery of the NWC at the end of the project. The NPV of the project with these assumptions is: NPV = −$2,430,000 + ($1,275,450/1.12) + ($817,650/1.122) + ($1,209,850/1.123) NPV = $221,767.55

Esfandairi Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.18 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.645 million in annual sales, with costs of $610,000. The project requires an initial investment in net working capital of $250,000, and the fixed asset will have a market value of $180,000 at the end of the project. The tax rate is 21 percent. a) What is the project's Year 0 net cash flow? Year 1? Year 2? Year 3? b) If the required return is 12 percent, what is the project's NPV?

a) Year 0 cash flow $ -2,430,000 a) Year 1 cash flow $ 970,250 a) Year 2 cash flow $ 970,250 a) Year 3 cash flow $ 1,362,450 b) NPV $ 179,537.00 Year 0 = −$2,180,000 − 250,000 = −$2,430,000 The cash outflow at the beginning of the project will increase because of the spending on NWC. At the end of the project, the company will recover the NWC, so it will be a cash inflow. The sale of the equipment will result in a cash inflow, but we also must account for the taxes that will be paid on this sale. So, the cash flows for each year of the project will be: OCF = (Sales − Costs)(1 − TC) + TC(Depreciation) OCF = ($1,645,000 − 610,000)(1 − .21) + .21($2,180,000/3) OCF = $970,250 In Years 1 and 2, the only cash flow is the OCF. In Year 3, the total cash flow will include the recovery of the NWC and the aftertax salvage value, so: Year 3 = $970,250 + 250,000 + 180,000 + ($0 − 180,000)(.21) Year 3 = $1,362,450 And the NPV of the project is: NPV = −$2,430,000 + $970,250(PVIFA12%,2) + ($1,362,450/1.123) NPV = $179,537.00

Opportunity costs are classified as ______ costs in project analysis. a) intangible b) relevant c) irrelevant d) sunk

b) relevant Reason(s) why it's not the other options: a) Opportunity costs are intangible; if the project is rejected, the benefit could still be received c) Opportunity costs are relevant costs, because they are costs that could be received if the project were not accepted d) Opportunity costs are not sunk costs; sunk costs are irrelevant in capital budgeting decisions, because they have already been paid and will not be recovered should the project be rejected

Operating cash flow is a function of _____. - depreciation - taxes - earnings before interest and taxes - salvage value of equipment - initial investment in equipment

- depreciation - taxes - earnings before interest and taxes

Winnebagel Corporation currently sells 20,000 motor homes per year at $103,000 each and 14,000 luxury motor coaches per year at $155,000 each. The company wants to introduce a new portable camper to fill out its product line; it hopes to sell 25,000 of these campers per year at $19,000 each. An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 2,700 units per year and reduce the sales of its motor coaches by 1,300 units per year. What is the amount to use as the annual sales figure when evaluating this project?

Sales due solely to the new product line are: 25,000($19,000) = $475,000,000 Increased sales of the motor home line occur because of the new product line introduction; thus: 2,700($103,000) = $278,100,000 in new sales is relevant. Erosion of luxury motor coach sales is also due to the new campers; thus: 1,300($155,000) = $201,500,000 loss in sales is relevant. The net sales figure to use in evaluating the new line is thus: $475,000,000 + 278,100,000 − 201,500,000 = $551,600,000

Dog Up! Franks is looking at a new sausage system with an installed cost of $385,000. This cost will be depreciated straight-line to zero over the project's five-year life, at the end of which the sausage system can be scrapped for $60,000. The sausage system will save the firm $135,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $35,000. If the tax rate is 21 percent and the discount rate is 10 percent, what is the NPV of this project?

First we will calculate the annual depreciation of the new equipment. It will be: Annual depreciation = $385,000/5Annual depreciation = $77,000 Now, we calculate the aftertax salvage value. The aftertax salvage value is the market price minus (or plus) the taxes on the sale of the equipment, so: Aftertax salvage value = MV + (BV − MV)TC Very often the book value of the equipment is zero as it is in this case. If the book value is zero, the equation for the aftertax salvage value becomes: Aftertax salvage value = MV + (0 − MV)TC Aftertax salvage value = MV(1 − TC) We will use this equation to find the aftertax salvage value since we know the book value is zero. So, the aftertax salvage value is: Aftertax salvage value = $60,000(1 − .21) Aftertax salvage value = $47,400 Using the tax shield approach, we find the OCF for the project is: OCF = $135,000(1 − .21) + .21($77,000) OCF = $122,820 Now we can find the project NPV. Notice we include the NWC in the initial cash outlay. The recovery of the NWC occurs in Year 5, along with the aftertax salvage value. NPV = −$385,000 − 35,000 + $122,820(PVIFA10%,5) + [($47,400 + 35,000)/1.105] NPV = $96,748.35

Bruno's Lunch Counter is expanding and expects operating cash flows of $26,900 a year for 6 years as a result. This expansion requires $92,700 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires $6,600 of net working capital throughout the life of the project. What is the net present value of this expansion project at a required rate of return of 13 percent? a) $17,218 b) $16,070 c) $11,404 d) $18,175 e) $14,834

c) $11,404 NPV = −$92,700 − 6,600 + 26,900(PVIFA13%, 6) + $6,600/1.136 NPV = $11,404

Sunk costs are costs that _____. a) cannot be measured b) will not contribute to profits in the long run even if a project is accepted c) have already occurred and are not affected by accepting or rejecting a project d) relate to other projects of the firm

c) have already occurred and are not affected by accepting or rejecting a project Reason(s) why it's not other options: a) Sunk costs are costs that have already occurred; they can be measured, but they can not be recovered if the project is not accepted b) Sunk costs are costs that have already occurred; whether or not they will contribute to profits is irrelevant, because they can not be recovered if the project is not accepted d) Sunk costs are costs that have already occurred; they may relate to other projects of the firm, but they can not be recovered if the project is not accepted

Quad Enterprises is considering a new 5-year expansion project that requires an initial fixed asset investment of $3.294 million. The fixed asset will be depreciated straight-line to zero over its 5-year tax life, after which time it will be worthless. The project is estimated to generate $2,928,000 in annual sales, with costs of $1,171,200. If the tax rate is 21 percent, what is the OCF for this project? a) $867,420 b) $1,602,531 c) $1,756,800 d) $1,526,220 e) $1,449,909

d) $1,526,220 Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get: OCF = (Sales − Costs)(1 − tC) + tCDepreciation OCF = ($2,928,000 − 1,171,200)(1 − .21) + .21($3,294,000/5) OCF = $1,526,220

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

recovery