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