FRL 367 Midterm I

Leveraged lease

A three-sided arrangement between the lessee, lessor, and lenders: - the lessor owns the asset and for a fee allows the lessee to use the asset -the lessor borrows to partially finance the asset -the lenders typically use a nonrecourse loan, meaning that the lessor is not obligated to the lender in case of a default by the lessee

Inversely

Accountants generally argue that a firm's financial strength is ____ related to the amount of its liabilities.

I, II, IV

All of the following are anticipated effects of a proposed project. Which of these should be included in the initial project cash flow related to net working capital? I. An inventory decrease of $5,000 II. An increase in accounts receivable of $1,500 III. An increase in fixed assets of $7,600 IV. A decrease in accounts payable of $2,100

Scenario analysis

Analysis of the effect on a project of different scenarios with each scenario involving many variable changes

Sensitivity analysis

Analysis of the effect on the project when there is some change in a critical variable, such as sales or costs

Equivalent annual cost

Approach that adjusts for the difference in useful life when comparing two machines

Break-even analysis

Approach that determines the sales needed to break even; is a useful complement to sensitivity analysis because it also sheds light on the severity of incorrect forecasts.

Financial break-even point (a project can exceed the accounting and cash break-even points but still be below the financial break-even point; this causes a reduction in your shareholder wealth)

As a shareholder of a firm that is contemplating a new project, would you be more concerned with the accounting break-even point, cash break-even point, or financial break even point?

Cash-break even, accounting break-even, financial break-even (for a project with an initial investment and sales afterwards, this order will always apply. Cash break-even is achieved first bc it excludes depreciation, accounting break-even is next bc it includes depreciation, financial break-even is last bc it includes the time value of money)

Assume a firm is considering a new typical project that requires an initial investment with sales, variable costs, and fixed costs over its life. Will the project usually reach the accounting, cash, or financial break-even point first? Which will it reach next? Last? Will this order always apply?

Stronger

BC the lease liability is hidden with an operating lease, the balance sheet of a firm with an operating lease LOOKS ______ (stronger/weaker) than the balance sheet of a firm with an otherwise identical capital lease. Given the choice, firms would probably classify all their leases as operating ones.

Residual value

Value of the property when the lease expires

All of these

Variable costs: -are zero when production is zero -change as the quantity of output changes -are exemplified by direct labor and raw materials -none of these -all of these

Cash flows

When performing a capital budgeting calculation, always discount _______. (Cash flows / earnings)

Steps of sensitivity analysis

1. Pick a variable 2. Vary it over range 3. NPV (or IRR) for each value

Sunk cost

A cost that has already occurred. Because these are in the past, they cannot be changed by the decision to accept or reject the project.

Decision trees

A graphical representation of alternative sequential decisions and the possible outcomes of those decisions. This graphical representation helps to identify the best course of action. When making decisions, we always start from far right, and work BACKWARDS.

Conditions for capitalized leases

A lease must be capitalized if any one of the following is met: 1. The PV of the lease payments is at least 90% of the fair market value of the asset at the start of the lease. 2. The lease transfers ownership of the property to the lessee by the end of the term of the lease 3. The lease term is 75% or more of the estimated economic life of the asset 4. The lessee can buy the asset at a bargain price at expiration.

Depreciation

A non-cash expense, only relevant because it affects taxes. Has two types: straight line & MACRS Schedule

Leveraged lease

A type of financial lease that is a tax-oriented leasing arrangement involving one or more third-party lenders

Sale and lease-back

A type of financial lease where a firm sells its existing assets to a financial company which then leases them back to the firm. This is often done to generate cash.

Scenario analysis

A variant of sensitivity analysis, which examines a number of different likely scenarios, where each scenario involves a confluence of factors.

Last year

After-tax Salvage Value occurs on year _____.

Monte Carlo simulation

An exercise that generates possible outcomes for a project based on a model of the underlying factors that drive project performance

Accounting break-even

Break-even measure, sales volume at which net income = 0

Financial break-even

Break-even measure, sales volume at which net present value = 0

Cash break-even

Break-even measure, sales volume at which operating cash flow = 0

After-tax salvage value

Capital spending that occurs at the last year

Matter

Cash flows _________ (matter / don't matter)

Lease

Contractual agreement between a lessee and lessor. Agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor, the owner of the asset

Example of variable costs

Costs of direct labor and raw materials

Fixed costs

Costs that are not dependent on the amount of goods or services produced during the period; usually is measured as costs per unit of time

Variable costs

Costs that change as the output changes, and they are zero when production is zero; common to assume that a ____ cost is constant per unit of output, implying that total ____ costs are proportional to the level of production

Cash inflow

Decreases in NWC

Depreciation tax shield

Depreciation deduction * Tax rate

Net working capital (NWC)

Difference between current assets and current liabilities

Contribution margin

Difference between sales price and variable cost per unit

Sensitivity analysis

Examines how sensitive a particular NPV calculation is to changes in underlying assumptions against ONE variable change (also known as what-if analysis and bop analysis) (best, optimistic, and pessimistic)

MACRS (for tax purposes, a firm would choose this bc it provides for larger depreciation deductions earlier. These earlier deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS & straight line is purely a time value issue, total depreciation is the same only timing differs)

Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation?

Aftertax riskless rate of interest

In a world with corporate taxes, firms should discount riskless cash flows at the ________.

Operating lease

Lease where it is usually not fully amortized, usually requires the lessor to maintain and insure the asset, and lessee enjoys a cancellation option

Change in NPV

NPV new - NPV old

Sensitivity ratio

NPV or OCF or NI / underlying variable

Erosion

Occurs when a new product reduces the sales, and hence, the cash flows of existing products

Synergy

Occurs when a new project increases the cash flows of existing projects

Side effects

Occurs when taking on a new project. May be positive (synergy) or negative (erosion)

Opportunity costs

Potential lost revenues/opportunities because firm takes on a project

Tax reduction

Principal benefit of long-term leasing

Examples of fixed costs

Rent per month or salaries per year (management salaries)

NPV rule

Rule that states managers should consider only the NPV and accept ALL projects with positive NPV in making capital budgeting decisions

Matter

Side effects _______ (matter / don't matter)

Monte Carlo simulation

Simulation of capital budgeting projects often viewed as a step beyond either sensitivity or scenario analysis; it is a further attempt to model real-world uncertainty

Don't matter

Sunk costs ______ (matter / don't matter)

Matter

Taxes _______ (matter / don't matter) -> We want incremental after-tax cash flows

Option to expand

The Mango Republic has just liberalized its markets and is now permitting foreign investors. Tesla manufacturing has analyzed starting a project in the country and has determined that the project has a negative NPV. Why might the company go ahead with the project? What type of option is most likely to add value to this project?

Nominal cash flow

The actual dollars to be received (or paid out)

Qualifications by the IRS for tax deductions

The lessee can deduct lease payments if the lease is- 1. The term must be less than 30 years 2. There can be no bargain purchase option 3. The lease should not have a schedule of payments that is very high at the start of thee lease and low thereafter 4. The lease payments must provide the lessor with a fair market rate of return 5. The lease should not limit the lessee's right to issue debt or pay dividends 6. Renewal options must be reasonable and reflect fair market value of the asset

Examples of real options

The option to expand, the option to abandon, the option to delay

Real options

The option to perform an action in managing a business or as part of a project

Real cash flows

The purchasing power of the actual cash flows

The option to expand

This type of real option has value if demand turns out to be higher than expected

The option to abandon

This type of real option has value if demand turns out to be lower than expected

The option to delay

This type of real option has value if the underlying variables are changing with a favorable trend

0

Total changes of NWC will equal to __.

True

True or False: Sensitivity analysis treats each variable in isolation. Changes in one variable will not influence other variables.

True

True or false: Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits of ownership to a party who can.

Operating lease

Type of lease where the period of contract is less than the life of the equipment and the lessor pays all maintenance and servicing costs

Real

Use _____ interest rates to discount real cash flows

Nominal

Use _______ interest rates to discount nominal cash flows.

A, B, D, F, G

Which of the following should be treated as an incremental cash flow when computing the NPV of an investment? A. A reduction in the sales of a company's other products caused by the investment B. An expenditure on plant and equipment that has not yet been made and will be made only if the project is accepted C. Costs of research and development undertaken in connection with the he product during the past three years D. Annual depreciation expense from the investment E. Dividend payments by the firm F. The resale value of plant and equipment at the end of the project's life G. Salary and medical costs for production personnel who will be employed only if the project is accepted

Changes in net working capital

Working capital rises over the early years of the project as expansion occurs, and drops at the later years of the project

C

Your company currently produces and sells steel shaft golf clubs. The board of directors wants you to consider the introduction of a new line of titanium bubble woods with graphite shafts. Which of the following costs are not relevant? A. Land you already own that will be used for the project, but otherwise will be sold for $700,000, its market value B. A $300,000 drop in your sales of steel shaft clubs if the titanium woods with graphite shafts are introduced C. $200,000 spent on research and development last year on graphite shafts

Financial lease

A long-term, noncancelable lease that generally requires the lessee to pay all maintenance fees

Cash outflow

Increases in NWC

Matter

Incremental cash flows ______ (matter / don't matter)

Bad reasons for leasing

-leasing and accounting income -100% financing, which suggests that leases do not permit a greater level of total liabilities than do purchases with borrowing -etc

Drawbacks of sensitivity analysis

-sensitivity analysis may unwittingly increase the false sense of security among managers -a deviation of fixed percentage ignores the fact that some variables are easier to forecast than others -sensitivity analysis treats each variable in isolation when, in reality, the different variables are likely to be related

Good reasons for leasing

-taxes may be reduced by leasing -the lease contract may reduce certain types of uncertainty -transaction costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset

Steps of Monte Carlo simulation

1. Specify the basic model 2. Specify a distribution for each variable in the model 3. The computer draws one outcome 4. Repeat the procedure 5. Calculate the NPV

How the lender is protected in a leveraged lease

1. The lender has a first lien on the asset 2. In the event of loan default, the lease payments are made directly to the lender.

Two things that occur in a sale and lease-back

1. The lessee receives cash from the sale of the asset 2. The lessee makes periodic lease payments, thereby retaining use of the asset

Early balloon payments

A lease with which one of these characteristics would not be qualified by the IRS? -term of 25 years -early balloon payments -lessee option to purchase asset at fair market value at lease expiration -no lease provision limiting the lessee' right to issue additional debt -lessee granted first option to meet a competing outside renewal offer

Revenues - Operating Costs - Depreciation

EBIT (taxable income)

True; fixed only over a predetermined time period

Fixed costs are not fixed forever. (True or False)

are constant over the short-run regardless of the quantity of output produced

Fixed costs: -can be ignored in scenario analysis since they are constant over the life of a project. -are constant over the short-run regardless of the quantity of output produced. -change as the quantity of output produced changes. -reflect the change in a variable when one more unit of output is produced. -are subtracted from sales to compute the contribution margin.

I, II, III

Fixed costs: 1. Are variable over long periods of time II. Must be paid even if production is halted III. Are generally affected by the amount of fixed assets owned by a firm IV. Per unit remain constant over a given range of production output

All cash flows and probabilities

In a decision tree, the NPV to make the yes/no decision is dependent on: -all cash flows and probabilities -on the path where the probabilities add up to one -only the cash flows from successful path -none of these -only the cash flows and probabilities of the successful paht

Aftertax riskless interest rate

In a world with corporate taxes, one determines the increase in the firm's optimal debt level by discounting a future guaranteed aftertax inflow at the ________.

Depreciation tax shield and lease payments

In the real world, many companies discount both the _____ & _____ at the aftertax interest rate on secured debt issued by the lessee

Net capital spending

Initial cash outflow at purchase of fixed assets (machines and equipments, factory, etc.) & sales of fixed assets at the end of the project life. => "Buying/selling machines"

Lease payment

Is like the debt service on a secured bond issued by the lesse

Financial lease (opposite of operating)

Lease where it does not provide for maintenance or service by the lessor, leases are fully amortizing, the lessee usually has a right to renew the lease at expiration, and cannot be cancelled.

$2,010,000

Marshall's & Co. purchased a corner lot in Eglon City five years ago at a cost $640,000. The lot was recently appraised at $810,000. At the time of the purchase, the company spent $50,000 to grade the lot and another $4,000 to build a small building on the lot to house a parking lot attendant who has overseen the use of the lot for daily commuter parking. The company now wants to build a new retail store on the site. The building cost is estimated at $1.2 million. What amount should be used as the initial cash flow for this building project?

more complex than sensitivity or scenario analysis

Monte Carlo simulation is: -none of these -more complex than sensitivity or scenario analysis -the method of analysis most widely used by executives -a very simple formula -the oldest capital budgeting technique

Taxable income (EBIT) - Income tax

Net income

is frequently affected by the additional sales generated by a new project

Net working capital: -requirements generally, but not always, create a cash inflow at the beginning of a project -expenditures commonly occur at the end of a project -is the only expenditure where at least a partial recovery can be made at the end of a project -is frequently affected by the additional sales generated by a new project -can be ignored in project analysis because any expenditures is normally recouped by the end of the project

Tax Shield approach

OCF = (Sales - Costs)(1-Tc) + Dep (Tc)

Bottom-up approach

OCF = Net Income + Depreciation where (NI= EBIT-Taxes); works only when there is no interest expense

Top-down approach

OCF = Sales - Costs - Taxes ; Don't subtract non-cash deductions

Tax effect

Occurs when the salvage value is different from the book value of the asset

Leases can be setup solely to avoid taxes

One key reason why the IRS is concerned about the structure of lease contracts is because: -firms that lease generally pay no taxes -leasing usually leads to bankruptcy -leases can be set up solely to avoid taxes -leasing leads to off balance-sheet-financing -lease payments can never be deducted as a business expense

Options have value

One of the fundamental insights of modern finance theory is -

Eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project

One purpose of identifying all of the incremental cash flows related to a proposed project is to: -make each project appear as profitable as possible for the firm -identify any and all changes in the cash flows of the firm for the past year so they can be included in the analysis -eliminate any cost which has been previously been incurred so that it can be omitted from the analysis of the project -include both the proposed and the current operations of a firm in the analysis of the project -isolate the total sunk costs so they can be evaluated to determine if the project will add value to the firm

Difference between operating lease and capital lease

Operating leases do not appear on the balance sheet, while capital leases do. (The present value of the lease payments of capital lease appears on both sides of balance sheet)

Must be disclosed in the lessee's annual report

Operating leases: -appear as offsetting items on the lessee's balance sheet -are fully expensed at the time the lease is established -are not included in the lessee's financial reports -are treated the same as a purchase -must be disclosed in the lessee's annual report

Matter

Opportunity costs _______ (matter / don't matter)

Lessor

Owner of the asset; either the asset's manufacturer or independent leasing company. If the _____ is an independent leasing company, it must first buy the asset from a manufacturer before delivering to the lessee.

Capital budgeting

Process of determing which projects (real assets) to invest in

Residential and nonresidential

Real property is separated into two classes: ______ & ______. The cost of _____ property is recovered over 27 1/2 years and ________ property over 39 years.

Because several variables are changed together

Scenario analysis is different than sensitivity analysis: -because scenario analysis deals with actual data vs. sensitivity analysis which deals with a forecast -because it is a "by the seat of the pants" technique -because several variables are changed together -because it is short and simple -because no economic forecasts are changed

How does sensitivity analysis interact with break-even analysis?

Sensitivity analysis can determine how the financial break-even point changes when some factors change (fixed costs, variable costs, revenue)

degree to which the net present value reacts to changes in a single variable

Sensitivity analysis helps you determine the: -degree to which the net present value reacts to changes in a single variable -level of variable costs in relation to the fixed costs of a project -net present value given the best and worst possible situations -degree to which a project is reliant upon the fixed costs -range of possible outcomes given possible ranges for every variable

wide range of values to multiple variables simultaneously

Simulation analysis is based on assigning a _____ and analyzing the results. -wide range of values to a single variable -narrow range of values to a single variable -single value to each of the variables -wide range of values to multiple variables simultaneously -narrow range of values to multiple variables simultaneously

the interest expense is equal to zero

The bottom-up approach to computing the operating cash flow applies only when: -no fixed assets are required for the project -the project is a cost-cutting project -both the depreciation expense and the interest expense are equal to zero -taxes are ignored and the interest expense is equal to zero -the interest expense is equal to zero

A sale and leaseback

The city of Plainview sold its maintenance facility in an all-cash transaction and used the proceeds to improve the city's financial position. The city then leased the building from the new owner on a non-cancellable basis. The city will be responsible for the maintenance and upkeep of the facility. These transactions illustrate: -an operating lease -a leveraged lease -a sale and leaseback -a fully amortized lease -both an operating lease and a sale and leaseback

Incremental cash flows

The difference between a firm's future cash flows with a project and those without the projects- "will this cash flow occur ONLY if we accept the project?"

Salvage value

The difference between the asset's sale price and its book value

The decision as to when a project should be started

The investment timing decision relates to: -how long the cash flows last once a project is implemented -how frequently the cash flows of a project occur -how frequently the interest on the debt incurred to finance a project is compounded -the decision to either finance a project over time or pay out the initial cost in cash -the decision as to when a project should be started

Avoid taxes

The reason the IRS is concerned about lease contracts is that many times they appear to be set up solely to ______.

Forecasting risk

The risk that a poor decision is made because of errors in projected cash flows. The danger is greatest with a new product bc the cash flows are probably harder to predict.

Lessor

Under a lease contract, the residual risk is borne by the _____ (lessor/lesse)

I & III

Which of the following are correct methods for computing the operating cash flow of a project assuming that the interest expense is equal to zero? I. EBIT + DEP - TAXES II. EBIT + DEP + TAXES III. NET INCOME + DEP IV. (SALES - COSTS) * (TAXES + DEP) * (1-TAXES)

I, II, III, IV

Which of the following are examples of an incremental cash flow? I. An increase in accounts receivable II. A decrease in net working capital III. An increase in taxes IV. A decrease in the cost of goods sold

II

Which of the following statements concerning variable costs is (are) correct? I. Variable costs minus fixed costs equal marginal costs. II. Variable costs are equal to zero when production is equal to zero. III. An increase in variable costs increases the operating cash flow.

direct labor costs

Which one of the following is most likely a variable cost? -property taxes -direct labor costs -management salaries -office rent -property insurance

A decrease in accounts receivable

Which one of the following will decrease net working capital of a firm? -a decrease in accounts payable -an increase in the firm's checking account balance -a decrease in accounts receivable -a decrease in fixed assets -an increase in inventory

Changes in operating costs related to the acquired asset

Which one of these can be ignored when valuing a purchase vs. a lease? -tax shield from depreciation -investment outlay for the asset -changes in operating costs related to the acquired asset -lease payments -taxes

Traditional NPV analysis is often too conservative (bc it ignores profitable options such as the ability to expand the project if it is profitable, or abandon the project if it is unprofitable. The option to alter a project when it has already been accepted has a value, which increases the NPV of the project)

Why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project?

Difference between sensitivity analysis and scenario analysis

With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values.

$80,000

Youngers Inc. paid $95,000, in cash, for a piece of equipment three years ago. Last year, the company spent $15,000 to update the equipment with the latest technology. The company no longer uses this equipment in its current operations and has received an offer of $80,000 from a firm who would like to purchase it. Youngers is debating whether to sell the equipment or to expand its operations such that the equipment can be used. When evaluating the expansion option, what value, if any, should Youngers assign to this equipment as an initial cost of the project?