Finance 325 Chapter 10

For the shark attractant project, why did we add back the firm's net working capital investment in the final year?

At the end of the project's life, the fixed assets will be worthless, but the firm will recover the money that was tied up in working capital. This will lead to cash inflow in the last year. On a purely mechanical level, notice that whenever we have an investment in net working capital, the same investment has to be recovered; in other words, the same number needs to appear at some time in the future with the opposite sign.

What is meant by the term depreciation tax shield?

Depreciation tax shield is defined as the tax saving that results from the depreciation deduction,calculated as depreciation multiplied by the corporate tax rate.

Explain what erosion is and why it is relevant.

Erosion is the cash flows of a new project that come at the expense of a firm's existing projects.

What is the definition of project operating cash flow? How does this differ from net income?

Project Operating Cash Flow is defined as the operating cash flow required for the day to day operation of the project. Project operating cash flow= Project cash flow+Project change in net working capital+Project capital spending

In setting a bid price, we used a zero NPV as our benchmark. Explain why this is appropriate.

Setting a zero NPV is appropriate because it ensures that underbidding does not happen. Since a zero NPV takes into account your expected rate of return, it ensures that the bidder does not lose out by lowering the bids too much.

Explain why interest paid is not a relevant cash flow for project evaluation.

we are interest in cash flow generated by assets. Interest paid cash flow to creditors, not cash flow from assets

A projects cash flow can be dividend into two classes

1. Cash Flows from capital requirements -Initial Cost (Acquiring project) -Net Salvage Value (Salvage value is the estimated value that the owner is paid when the item is sold at the end of its useful life, selling off assets) -Net Working Capital(Initial investment and changes in NWC over projects life) 2. Operating Cash flows( Cash flows that arise with the economic activity associated with project) -Revenues -Operating Expenses -Taxes on Operating profit.

What are the relevant incremental cash flows for project evaluation?

A relevant cash flow for a project is a change in the firm's overall future cash flow that comes about direct consequence of the decision to take that project. The relevant cash flows are the incremental cash flows that help you make a decision to take on the project. The incremental cash flows for project evaluation consist of any or all changes in the firm's future cash flows that are a direct consequence of taking the project. The relevant cash flows that should be included in a capital budgeting analysis. (So if you start the company with 10 million and gain 15 million. Your incremental cash flow is 5 million.)

What are the top-down and bottom-up definitions of operating cash flow?

In the Top-down approach: we start at the top of the income statement with sales and work our way down to net cash flow by subtracting costs,taxes,and other expenses. Along the way, we simply leave out any non cash items such as depreciation. The bottom-up approach, we start with the accountant's bottom line( net income) and add back any non cash deductions such as depreciation. It is crucial to remember that this definition of operating cash flow as net income plus depreciation is correct only if there is no interest expense subtracted in the calculation of net income.

Why is it important to consider changes in net working capital in developing cash flows? What is the effect of doing so ?

It is important to consider changes in net working capital in developing cash flows because net working capital requirements change as sales change. Every year businesses will generally either add to or recover some of its project net working capital. An increase in net working capital is a cash outflow it shows positive sign represents net working capital returning to the firm.

What is a Sunk cost? An opportunity cost?

Sunk Cost is a cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision. (NOT INCLUDED IN INCREMENTAL CASH FLOWS) An opportunity cost is slightly different; it requires us to give up a benefit. It is defined as the most valuable alternative that is given up if a particular investment is undertaken.

What is the stand- alone principle?

The assumption that evaluation of a project may be based on the project's incremental cash flows is known as the stand-alone principle. 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 "mini firm" with its own future revenues and costs, its own assets,and,of course,its own cash flows.

How is depreciation calculated for fixed assets under current tax law? What effects do expected salvage value and estimated economic life have on the calculated depreciation deduction?

Under Modified ACRS Depreciation( MACRS) is that every asset is assigned to a particular class. An asset's class establishes its life for tax purposes. Once an asset's tax life is determined, the depreciation for each year is computed by multiplying the cost of the asset by a fixed percentage. The expected salvage value( what we think the asset will be worth when we dispose of it) and the expected economic life( how long we expect the asset to be in service) are not explicitly considered in the calculation of depreciation.

Under what circumstances do we have to worry about unequal economic lives? How do you interpret the EAC?

The EAC( Equivalent annual cost) approach is appropriate when comparing mutually exclusive projects with different lives that will replaced when they wear out. This type of analysis is necessary so that the projects have a common life span over which they can be compared. For example, if one project has a three-year life and the other has a five-year life, then a 15- year horizon is the minimum necessary to a place the two projects on an equal footing, implying that one project will be repeated five times and the other will be repeated three times. Note the shortest common life may be quite long when there are more than two alternatives and/or the individual project lives are relatively long. Assuming this type of analysis is valid, implies that the project cash flows remain the same over the common life, thus ignoring the possible effects of inflation,changing economic conditions, increasing unreliability of cash flow estimates that occur far into the future, and the possible effects of future technology improvement that could alter the project cash flows.

3 General Rules to Follow for project cash flows.

1. Only Cash flow is relevant (Cash flow is the difference between actual dollars taken in and actual dollars paid out.) Operating Cash flow= EBIT(1-T)+ Depreciation 2. Always estimate cash flow on an incremental basis. (The change in the firms total cash flow that follows from accepting a project ! Its the additional cash flow added to the firms total cash flow) -If the firms project has a value of 110 million , and it increase to 115 million. Their is a 5 million incremental cash flow in the project. 3. Be consistent in the treatment of inflation -Use nominal interest rates to discount nominal cash flows. -Use real interest rates to discount real cash flows. -You will get the same results,whether you use nominal or real figures.