FNAN 401- Chapter 6: Incremental Cash Flow the key to Capital Budgeting.
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
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
Which of the following is an example of an opportunity cost.
rental income likely to be lost by using a vacant building for an upcoming project
What are the two sets of accounting books?
shareholders' books tax books
As a general rule, when estimating equivalent annual costs, Blank______ cash flows should be used.
Real
Nominal interest rate − Inflation rate approximates the ----- interest rate.
Real
Which of the following refers to a cash flows purchasing power
Real cash flow
What is the formula for real interest rate
Real interest rate = Nominal interest rate − Inflation rate
Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?
- Book value represents the purchase price minus the accumulated depreciation. - 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
At the end of a project, a company sold a machine for $50,000 with a book value of $10,000. Assuming a tax rate of 21 percent, what is the after-tax salvage value?
.21*(50000-10000) = 8400 50,000 - 8,400 = 41,600
Three ways to find the OCF
1. The top-down approach 2. The bottom-up approach 3. The tax shield method
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?
200,000 -190,636 - 1144 = 8,220
What is the real interest rate if the nominal annual interest rate is 10 percent, and the annual inflation rate is 4 percent?
5.77%
Incremental cash flows of a project are changes in a firm's cash flows that occur as a direct consequence of Blank______.
Accepting a project
When analyzing a project, sunk costs Blank______ incremental cash outflows.
Are not
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 investment cash flows will increase.
Which of the following should be discounted when determining the feasibility of a capital budgeting project(s)
Cash flows
Corporate finance emphasizes Blank______, while financial accounting emphasizes Blank______.
Cash flows, earnings.
How does depreciation affect the operating cash flows?
Depreciation expense reduces the taxable income and taxes, and increases the operating cash flow
When comparing projects with unequal lives, one should use which of the following methods Blank______.
Equivalent annual costs
When determining the incremental cash flows side effect known as ---
Erosion or synergy
Firms generally maintain two sets of books, one for the IRS and the other for the purposes of generating financial statements according to the Blank______.
FASB
True or false: Discounting involves determining the future value of present cash flow.
False
True or false: Opportunity costs can be ignored when determining the financial feasibility of a project.
False
Interest on municipal bonds is Blank______
Ignored for tax purposes while FASB treats the interest as income.
An increase in depreciation expense will Blank______ cash flows from operations.
Increase
If sales are made on credit, net working capital will ___.
Increase
If the inflation rate increases, the nominal rate of interest will Blank______.
Increase
If the tax rate increases, the value of the depreciation tax shield will ______.|
Increase
Synergy will --- the sales of existing products.
Increase
Buying new cost-cutting equipment affects operating cash flows by Blank______.
Increasing taxes, increasing depreciation deduction, increasing pretax income
---- cash flows are the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.
Incremental
The computation of equivalent annual costs is useful when comparing projects with unequal Blank______.
Lives
When interest rates and inflation rates are Blank______, the approximation of the real interest rate becomes Blank______.
Low, good High, poor
When comparing projects with different lives, one should choose the project with the Blank______ equivalent annual cost.
Lower
When bidding for a job, a competing firm can use the NPV approach to determine its bid. Once the bid is submitted, the firm will win the contract for the project if their bid is the Blank______.
Lowest
According to the bottom-up approach, what is the OCF if EBIT is $600, depreciation is $1,800, and the tax rate is 30 percent?
Net Income = EBIT - Taxes Bottom-up approach = NI +Depreciation (600-180) + 1800 = 2220
Identify the three main sources of cash flows over the life of a typical project.
Net cash flows from sales and expenses over the life of the project. Cash outflows from investment in plant and equipment at the inception of the project. Net cash flows from salvage value at the end of the project.
The bottom-up approach to calculating OCF starts with Blank______.
Net income
What is the difference between nominal cash flow and real cash flow
Nominal cash flow is the actual dollars to be received. Real cash flow refers to the cash flow's purchasing power.
The equation for determining the real interest rate has the nominal interest rate in the Blank______ and the inflation rate in the Blank______.
Numerator, denominator
What is the depreciation tax shield if EBIT is $600, depreciation is $1,800, and the tax rate is 21 percent?
OCF = (Sales -Cash costs )* (1-Tax rate) + Depreciation * Tax rate 1800*.21 = 378
Which of the following is the equation for estimating operating cash flows using the tax shield approach
OCF = Sales - Cash Costs * (1- Taxes) + Depreciation *Tc OCF = (Revenue - Expenses) × (1 - Tax rate) + Depreciation × Tax rate
What is the equation for estimating operating cash flows using the top-down approach?
OCF = Sales - Cash costs - Taxes
Using your personal savings to invest in your business is considered to have an ----- ----because you are giving up the use of these funds for other investments or uses, such as a vacation or paying off a debt.
Opportunity cost
Under capital budgeting, required working capital is classified as a cash Blank______.
Outflow
Under capital budgeting, opportunity costs are cash Blank______.
Outflows
Management may look Blank______ to shareholders and pay Blank______ tax on reported profit.
Profitable, no
If the nominal rate is 5 percent and the annual rate of inflation is 2 percent, what is the real rate of return?
Real rate of return = 1+Nominal rate/ 1+Inflation rate RR = (1+.05)/ (1+.02) -1 = 0.0294 = 2.94%
Erosion will --- the sales of existing products.
Reduce
Opportunity costs are classified as Blank______.
Relevant costs
When using nominal cash flows, the NPV will be Blank______ when using real cash flows.
Same as
It is appropriate to use the approximate formula for estimating the real interest rate when Blank______.
The interest rate and inflation rates are low
When a firm evaluates a proposal to make an existing facility more cost-effective, the cost savings must be large enough to justify Blank______.
The necessary capital expenditure
What approach does the following formula describe? OCF = (Revenue - Expenses) × (1 - T) + Depreciation × T
The tax shield approach
Which of the following is (are) true about allocated costs?
These costs benefit more than on project. These costs are allocated to more than one project
Allocated cost should be views as a cash outflow. True or false
True
Capital budgeting must be evaluated on an incremental basis, ignore the sunk cost. True or false
True
True or false: NPV will be the same regardless of whether nominal or real cash flows are used
True
Erosion refers to
When a new product reduces the sales, and hence the cash flow of existing products.
Sometimes when the low bidder wins the bid on a project, it is because they have underbid the project. In other words, the bid they have submitted probably won't even cover the costs of the project. When this happens, the low bidder is said to suffer from the Blank______.
Winner's curse
Incremental cash flows of a project are changes in a firm's cash flows that occur as a direct consequence of Blank_____
accepting a project
Discounting is the process of Blank______.
calculating the present value of either a lump sum or a series of cash flows
Sunk costs are costs that Blank______.
have already occurred and are not affected by accepting or rejecting a project
As depreciation Blank______, operating cash flows will Blank______.
increases; increase decreases; decrease
Investment in net working capital arises when Blank______.
inventory is purchased. cash is kept for unexpected expenditures. credit sales are made
Allocated costs must be treated as relevant or incremental costs Blank______.
only if the costs being allocated are affected by the proposed project