FINAN 3040 Chapter 9

Discount Cash Flows, Not Profit

Discount actual cash flows, not net income. Discounting cash flows allows for the proper placement of all incremental inflows and outflows when they actually occur in the project timeline and can be valued (discounted) correctly Using accounting income, rather than cash flow, could lead to erroneous decisions

Incremental Cash Flows

The net additional cash flows generated by undertaking a project, both inflows and outflows. Capital budgeting decisions are based on comparison of a project's initial investment outlay to the future incremental cash flows of the project and its terminal cash flow

Inflation Rules:

Be consistent in how you handle inflation. Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows. Note: You will get the same results, whether or not you use nominal or real values. Adjustments for inflation are often made to cash flows occuring in projects greater than 1 year.

A new inventory system will immediately reduce inventory levels by $100,000. If this reduction is permanent and the cost of capital is 13%, how does the net working capital change affect company value? A) NPV increases by $13,000. B) Company value will not change. C) Company value increases by $100,000. D) Company value increases by $769,231.

C

A tax shield is equal to the reduction in a firm's: A) taxable income resulting from a decrease in long-term debt. B) net income caused by depreciation. C) total tax liability resulting from a tax deductible expense. D) taxable income resulting from depreciation.

C

In what manner does depreciation expense affect investment projects? A) It increases cash flows by the amount of the depreciation expense. B) It reduces taxes by the amount of the depreciation expense. C) It reduces taxable income by the amount of the depreciation expense. D) It reduces cash flows by the amount of the depreciation expense.

C

The correct method to handle overhead costs in capital budgeting is to: A) allocate a portion to each project. B) ignore them in all cases. C) ignore all except incremental amounts. D) allocate them to projects with the highest NPVs.

C

What is the amount of the annual depreciation tax shield for a firm with $200,000 in net income, $75,000 in depreciation expense, and a 35% marginal tax rate? A) $70,000 B) $43,750 C) $26,250 D) $75,000

C

A firm invests $10 million in a new stamping machine. It depreciates it straight line for tax purposes over 5 years. The tax rate is 30%, inflation is 4% a year, and the discount rate is 8%. What is the PV of the depreciation tax shield? A) $2,579,497. B) $3,000,000. C) $600,000. D) $2,395,626.

D

A firm plans to purchase a $50,000 asset that will be depreciated straight-line over a 5-year life to a zero salvage value. What is the present value of the resulting depreciation tax shield if the tax rate is 35% and the discount rate is 10%? A) $10,866.67 B) $37,908.18 C) $17,500.00 D) $13,267.75

D

The statement "We've got too much invested in that project to pull out now" possibly illustrates the need to: A) reduce net working capital assigned to the project. B) reduce discount rates to improve NPV. C) switch to an accelerated method of depreciation. D) recognize sunk costs.

D

What is the annual depreciation tax shield for a profitable firm in the 30% marginal tax bracket with $100,000 of annual depreciation expense? A) $65,000 B) $35,000 C) $10,500 D) $30,000

D

When is it appropriate to include sunk costs in the evaluation of a project? A) If they improve the project's NPV B) If they are considered to be overhead costs C) Whenever they are relatively large D) Never

D

Which one of the following categories would be least likely to require annual adjustments in a capital budgeting analysis due to the effects of inflation? A) Sales B) Working capital C) Expenses D) Depreciation expense

D

Identifying Cash Flows

- Discount Cash Flows, not Profits. - Discount Incremental Cash Flows. - Discount Nominal Cash Flows by the Nominal Cost of Capital. - Separate Investment & Financing Decisions.

. Which of the following correctly adjusts for depreciation when calculating a project's operating cash flow? A) (revenues - cash expenses) × (1 - tax rate) + (tax rate × depreciation). B) ignore depreciation since it is not a cash flow. C) pretax profit + depreciation tax shield. D) after-tax profit - depreciation.

A

Allocations of overheads should not affect a project's incremental cash flows unless the: A) project actually changes the total amount of overhead expenses. B) overhead is not currently fully allocated to existing projects. C) overhead will not be recovered at the end of the project. D) accountant is required to allocate costs to this project.

A

An investment of $120,000 can be depreciated for tax purposes straight line over 6 years. The corporate tax rate is 40%. When calculating cash flow: A) the company should add a depreciation tax shield of $8,000 a year to after-tax (revenues less cash expenses) B) no adjustment should be made for depreciation since it is not a cash expense. C) the company should add a depreciation tax shield of $20,000 a year to after-tax (revenues less cash expenses) D) the company should deduct a depreciation tax shield of $8,000 a year from after-tax (revenues less cash expenses)

A

Capital budgeting proposals should be evaluated as if the project were financed: A) entirely by equity. B) with the highest cost source of funds, to be safe. C) half by debt and half by equity. D) entirely by debt.

A

Investments in working capital: A) reduce project NPV. B) are simply accounting entries and do not affect NPV. C) increase NPV because they make the project more valuable. D) do not matter because the cash is generally recovered when the project ends.

A

What is the NPV of a 6-year project that costs $100,000, has annual revenues of $50,000 and cash expenses of $15,000? Assume the investment can be depreciated for tax purposes straight-line over 6 years, the corporate tax rate is 35%, and the discount rate is 14%. A) $11,151.53 B) Ϋ$15,560.04 C) $3,411.14 D) $14,782.09

A

What is the operating cash flow for a firm with $500,000 profit before tax, $100,000 depreciation expense, and a 35% marginal tax rate? A) $425,000 B) $325,000 C) $260,000 D) $360,000

A

What is the undiscounted cash flow in the final year of an investment, assuming $10,000 after-tax cash flows from operations, $1,000 from the sale of a fully depreciated machine, a $2,000 investment in working capital, and a 35% tax rate? A) $12,650 B) $12,600 C) $14,000 D) $8,450

A

Which one of the following formulas is incorrect? A) Depreciation tax shield = depreciation × (1 - tax rate) B) Operating cash flow = (revenues - cash expenses) × (1 - tax rate) + (depreciation × tax rate) C) Operating cash flow = net profit + depreciation D) Operating cash flow = revenues - cash expenses - taxes

A

Which one of the following is not accurate in depicting the cash flows from operations for an all-equity firm? A) (revenues - expenses - taxes) B) (revenues - cash expenses)(1 - tax rate) +(depreciation × tax rate) C) (revenues - cash expenses - taxes) D) (net profit + depreciation)

A

The NPV of an investment proposal becomes negative solely as a result of allocating a portion of the corporation president's salary. It is most likely the case that: A) the salary should be considered an opportunity cost of the project. B) the project should be accepted. C) rejecting the project is the correct decision. D) the allocation should be postponed until the project is accepted

B

The opportunity cost of an asset: A) should be depreciated annually. B) should be used to discount the project cash flows. C) is important only for parcels of land. D) is typically ignored in capital budgeting.

B

The rationale for not including sunk costs in capital budgeting decisions is that they: A) are usually small in magnitude. B) have no incremental effect on project cash flows. C) revert at the end of the investment. D) reduce the project's net present value

B

When a depreciable asset is ultimately sold, the sales price is: A) fully taxable. B) taxable to the extent that the sales price exceeds book value. C) nontaxable. D) nontaxable only if accelerated depreciation was used.

B

When calculating cash flow from operations, one should: A) deduct the depreciation tax shield from after-tax profit. B) add depreciation to after-tax profit. C) use after-tax profit and ignore depreciation. D) subtract depreciation since it represents the cost of replacing worn-out equipment.

B

Which of the following is true of the depreciation tax shield? A) The real value of the depreciation is fixed. B) It is not altered by inflation. C) It increases annually with the rate of inflation. D) It decreases annually in nominal terms.

B

Cash Flow Inclusion Rule:

To determine whether or not a cash flow should be included in a project analysis, as, this question.

Seperate Investment & Financing Decisions

When valuing a project, ignore how the project is financed. Following the logic from incremental analysis ask the following questions: Is the project existence dependent on the financing? If no, you must seperate financing and investment decisions. Assume projects are financed by equity. Why?---Cost of Capital