chapter 11

what is the asset's value on the firm's balance sheet determined by accounting principles

book value

we ignore the cost of _____ when determine project cash flows

financing

most investments have what type of lives

finite

for most investment projects, NFAI ______ at first

increase

NFAI may ______ if firm continues to acquire new assets or _______ if it sells assets in excess of the depreciation charge

increase; decrease

the additional after-tax cash flows--outflows or inflows--that will occur only if the firm makes the investment

incremental cash flows

when analyzing an investment opportunity, it is critical to focus only on the

incremental cash flows

what goes into periodic cash flows

incremental operating cash flow + additional purchase/sale of fixed assets + additional changes in working capital

what is included in periodic cash flows

incremental revenues and operating expenses

changes to working capital do not trigger

incremental taxes

no matter what there will be what type of taxes in the periodic cash flow

incremental taxes

we do not deduct ______ separately from the project cash flows? why?

interest expenses, it would be double counting them

the tax on the sale of an asset is either an additional tax payment when the sale proceeds ______ asset's book value or a tax refund when the sale proceeds are _____ asset's book value

exceed; less than

net working capital will show up as a cash _________ as the firm depletes inventories, collects a/r... etc.

inflow

increases in a/p and expense accruals are

inflows of cash

terminal cash flow calculation includes any change in____ _____ ____ that occurs at the end of the investment's life

net working capital

what goes into a initial cash flow

purchase/sale of fixed asset + buildup/recovery of working capital

what is used to find assets with an infinite life

tv formula

a typical investment is what

up front, initial cash flow

Which of the following is an example of a sunk cost? · Interest expense needed to service debt. · Amount needed to build a manufacturing facility. · Amount spent on a test market.

· Amount spent on a test market.

Which of the following cash flows should be included in incremental free cash flows? · Capital expenditures necessary to fund the new project. · Interest expense generated from debt to finance the project. · Stock flotation costs to raise new equity to finance the project.

· Capital expenditures necessary to fund the new project. -- Capital expenditures necessary to fund the new project should be included in incremental free cash flows. While the accounting cost of new assets will be depreciated over the asset's useful life the actual cash outlay to purchase the asset typically occurs on the front end of the project and is a relevant incremental cash flow.

The major components of a project's cash flows are an initial investment, operating cash flows, and __________. · the CEO's salary · a terminal cash flow · sunk costs

· a terminal cash flow

The sale of an ordinary asset for its book value results in: · no tax benefit. · a capital loss. · a capital gain.

· no tax benefit.

The tax treatment regarding the sale of existing assets that are sold for more than the book value but less than the original purchase price results in a(n) ________. a. ordinary tax benefit b. capital gain tax liability c. recaptured depreciation taxed as ordinary income d. capital gain tax liability and recaptured depreciation taxed as ordinary income

c. recaptured depreciation taxed as ordinary income

if a firm is making an investment that expands its activities in some way (building new manufacturing capacity, opening new retail space, launching new product, what are the incremental cash flows?

exclusively expansion project

when is the loss deduced from ordinary income when the sale price is less than the book value

if asset is depreciable and used in business

what is tax treatment if the assets are sold for a price less than its book value

if the asset is depreciable and used in business, loss is deducted from ordinary income

what is the incremental after-tax cash flow occurring at the beginning of the project's life (i.e. time zero)

initial cash flow

most investments begin with an ______, _________ and end with

initial cash flow, produce periodic cash flows from operating assets; end with a terminal cash flow

if the net working capital were negative it would be shown as an

initial infloow

the increased investment in working capital is treated as an

initial outflow

any added costs that are necessary to place the new asset into operation

installation costs

why is the preliminary analysis a sunk cost

it cannot recover the costs of analyzing the investment opportunity in local market

Once preliminary analysis is completed those costs are ___ and should not influence the company's decision to open a new store

sunk

what are cash outflows that have already occurred (past outlays) and cannot be recovered regardless of the final investment decision

sunk costs

because changes to working capital do not trigger incremental taxes, there are no _______

tax consequences

the before tax cash inflow from the proceeds from the sales of an asset is usually subject to some type of

tax treatment

the final net incremental after-tax cash flow/cash flow occurring at end of project's life is called

terminal cash flow

when an investment project reaches the end of its life, the incremental cash flow that comes from liquidating the investment in its final year of service is the

terminal cash flow

if an investment is infinite, instead of producing the terminal cash flow, the investment has a

terminal value

recaptured depreciation is found by subtracting

the initial purchase price minus the book value

deducting the cost of financing (int exp) from project cash flows does what

understates projects value

Duke Corporation bought a computer system several years ago at a cost of $156,000. Since that time, the company has taken $100,000 in depreciation. In the current year, they sell the computer for $80,000. How much depreciation must be recaptured upon the sale of the computer? · $0 · $24,000 · $100,000 · $80,000

· $24,000 --The starting point in the calculation of depreciation recapture is calculating the gain on the sale. The gain is the difference between the sales price of $80,000 and the book value of $56,000 ($156,000 purchase price - $100,000 depreciation) and equals $24,000. Depreciation is recaptured to the lesser of depreciation taken and the gain on the sale, making depreciation recapture $24,000.

The installed cost of an asset minus its accumulated depreciation is known as __________. · Book value · Market value · Intrinsic value

· Book value

How does depreciation affect the taxes owed by a firm? · Depreciation has no effect on tax liability as it is a non-cash expense. · Depreciation reduces the tax owed by a firm over the life of the asset. · Depreciation increases the tax owed by a firm over the life of an asset.

· Depreciation reduces the tax owed by a firm over the life of the asset. --Although the initial outlay of cash for a new asset often happens in the first year, depreciation is recognized over the life of the asset and reduces the tax owed by the firm. --The modified accelerated cost recovery system (MACRS) is a IRS depreciation method that allows you to expense an asset more rapidly and therefore generate higher depreciation tax shields in the early years of a project.

Which of the following is a relevant opportunity cost that should be considered an incremental cash flow? · Lost interest income · Lost revenue from reduced sales in other products · Lost facility rental income

· Lost facility rental income --This is due to the fact that you are now using a facility for your new project that could be rented out to someone else. Since this resource has a valuable alternative use you need to factor that lost income in as a relevant cash flow.

Which of the following statements is correct with respect to incremental operating cash flows? · Operating cash flows are calculated using incremental revenues and expenses without respect to additional taxes and depreciation. · To calculate incremental operating income, depreciation must be subtracted to calculate the change in after-tax operating income. · Depreciation expense reduces incremental operating cash flows.

· To calculate incremental operating income, depreciation must be subtracted to calculate the change in after-tax operating income.

Firm XYZ is going to expand operations and has notified a firm that is leasing some of Firm XYZ's facility that it will need to find another facility and relocate. Firm XYZ's loss of lease income is __________. · a cash outflow that should be considered in the expansion decision · a cash inflow that should be considered in the expansion decision · irrelevant to the expansion decision since Firm XYZ owns the property

· a cash outflow that should be considered in the expansion decision

If a firm sells a depreciable asset for less than the asset's book value it will result in __________. · a tax increase · a tax savings · no tax impact

· a tax savings -- If a firm sells a depreciable asset for less than the asset's book value it will result in a tax savings. Selling the asset for an amount less than the book value amount will result in a loss that can be used to offset ordinary income and result in a lower tax liability (i.e. tax shield). --A tax liability results from selling an asset for more than its current book value. And, if an asset is sold for book value there are no tax consequences.

We only want to consider incremental earnings in the capital budgeting process. Incremental earnings are the: · additional sales and costs associated with the project. · externalities generated from the project. · capital expenditures minus the salvage value of assets.

· additional sales and costs associated with the project.

When a business undertakes a new project it will often need to invest additional funds in net working capital to cover items such as: · product cannibalization costs. · increased inventory levels. · higher installation costs.

· increased inventory levels. --When a business undertakes a new project it will often need to invest additional funds in net working capital to cover items such as increased inventory levels. Changes in net working capital are easy to forget about but any increased level of business typically requires additional investment in inventory, accounts receivables, and other current asset accounts. While a portion of this will be funded through a natural increase in liabilities in most cases this will not fund the entire increase in current assets.

The relevant cash flows of a project are best described as: · accounting cash flows. · incremental cash flows. · incidental cash flows.

· incremental cash flows.

When a firm expands operations it will also require additional investment in __________. · accounts payable · sunk costs · net working capital

· net working capital

One of the risks that a firm faces when engaging in foreign direct investment is the risk of the firm's asset being seized which is a component of __________. · currency risk · political risk · cultural risk

· political risk

this is desirable because it accelerates depreciation tax savings and postpones higher taxes to later years

bonus depreciation

an investments terminal cash flow takes one of two forms

1) reaches end of its useable life and is liquidated 2) lifespan is indefinite, so there is a terminal value not terminal cash flow

what is tax consequence if the assets are sold for a price greater than its book value

21% of gain is a tax liability

what is tax consequence if the assets are sold for a price less than its book value

21% of loss is a tax savings

what does NFAI stand for

Net fixed asset investment

what is the investment made in fixed assets each period, or, equivalently the change in gross fixed assets from one period to the next

Net fixed asset investment

what is the terminal value equal to

PV of expected/ after-tax cash flows over an infinite horizon

what matters? a) whether an investment creates or destroys value b) net income or earnings

a) whether an investment creates or destroys value

Which of the following must be considered in computing the terminal value of a replacement project? a. After-Tax Proceeds from the Sale of a New Asset b. Operating Cash Flow for the Final Year c. Before-Tax Proceeds from the Sale of an Old Asset d. Net operating profit after tax

a. After-Tax Proceeds from the Sale of a New Asset

Which of the following would be considered a relevant incremental cash flow when evaluating an investment opportunity? a. Tax savings from the expensing of a capital asset associated with the investment. b. Interest expense associated with debt financing used to finance the investment. c. Cost of market research to assess an investment's viability. d. Dividend payments for preferred stock used to finance the investment.

a. Tax savings from the expensing of a capital asset associated with the investment.

You are thinking about going to graduate school to earn a masters degree, which you hope will allow you to earn more money. Which of the following is NOT an incremental cash flow associated with your decision to extend your schooling versus going into the workforce when you finish your undergraduate degree? a. the cost of living expenses, such as rent and food, while you are in graduate school b. the cost of tuition c. the lost income you could have earned by working rather than staying in school d. the cost of books and other supplies required for your graduate studies

a. the cost of living expenses, such as rent and food, while you are in graduate school

the difference between the old asset's sale proceeds and any applicable tax liability or refund related to sale

after-tax proceeds from sale of old asset

what is tax treatment if the assets are sold for a price greater than its book value

all gains above book value are taxed as ordinary income

the cost of the new asset plus its installation costs =

asset's depreciable value

Should financing costs such as the returns paid to bondholders and stockholders be considered in computing after-tax operating cash flows? Why or why not? a. Yes, because the project cash flows belong to bondholders and stockholders. b. No, financing costs are embedded in the project's required rate of return. c. No, financing costs are an incremental cash flow for capital budgeting. d. Yes, because bondholders and stockholders both have a required return

b. No, financing costs are embedded in the project's required rate of return.

the proceeds from the sale of an asset are the ___________ cash inflows net of any removal costs

before-tax

The analysis of an investment project is most likely to include a terminal value calculation when ________. a. the project has a lifespan of 5-10 years b. the project cash flows definitely come to an end at a certain time c. the project has an unlimited life d. the asset being purchased as no salvage value

c. the project has an unlimited life

what is the final step in estimating the periodic cash flows for investment projects?

calculate incremental cash flows

the gain when the sale of an asset is for more than its book value is made up of two parts:

capital gain and recaptured depreciation

the investment's incremental cash flow is the difference betweenwaht

cash flow the firm produces if it invests minus cash flow it produces without investing

why do the project's incremental cash flows consist only of the new cash flows created by the investment?

cash flows from existing store were not affected by decision to build a new one

the initial cash flow nets all of the incremental cash flows that occur at the start of the project and subtracts all

cash outflows from any cash inflows

to estimate a project's incremental cash flows for replacement projects, you need to forecast cash flows from new store and compare it with what

compare with those cash flows the old store would have generated had it not bee remodeled

the cash outflow necessary to acquire a new asset

cost of new asset

for replacement projects, the initial cash flow includes what

cost of new equipment as well as any cash flows associated with removal and sales of old equipment

what is a non cash expense

depreciation

when depreciation impacts cash flows because it reduces taxes by an amount known as the

depreciation tax shield

what does net refer to in NWCI

difference between change in current assets and change in current liabilites

what accounts for interest expenses and other financing cots in the capital budgeting analysis

discounting cash flows

as long as there are no change in working capital that occur after the initial cash flow, the amount recovered at termination will ________ what was invested up from

equal

what does NWCI stand for

net working capital investment

is the change in net working capital taxable

no it is not taxable

if the assets are sold for its book value, there are

no tax consequence on the sale

should sunk costs be included in the project's incremental cash flows

no, they are irrelevant

because initial cash flow occurs at time zero, there will be no

operating cash flow

what refers to the periodic incremental cash flows that most projects generate by enabling a firm to produce/sell goods or services

operating cash flow (OCF)

if the firm doesn't invest, it continues to operate the original asset and sell it at the end up its life, the sale represent a _______ _____ that is _______-

opportunity cost that is subtracted

if a company did not refurbish a space, it could sell, and the proceeds that it gives up by refurbishing the space rather than selling it represent a ______, that should be ______ from project's other cash flows

opportunity cost, deducted

what are cash flows that the firm could have realized from the best alternative use of assets already in place

opportunity costs

increases in cash, a/r and inventories are

outflows

once the initial investment is placed, it generates what

periodic cash flows

the net incremental after-tax cash flow occurring each period during a project's life

periodic cash flows

after a firm makes a new investment, it will generate a stream of

periodic cash fows

for an investment with an infinite lifespan, the terminal value is the value of a

perpetuity

what are the incremental free cash flows (after taxes) that a firm expects a project to generate over its life

project cash flows

for expansion projects, there are cash outflows from

purchase of new asset or an increase in net working capital

the cost of a new asset is just the

purchase price

capital gain is found by subtracting the

sale price minus the initial purchase price

what does the terminal cash flow include

sales of fixed assets + cleanup/shutdown costs + recovery of working capital

for replacement projects, cash inflows may also occur that involve

selling off old assets before bringing new ones into service

installation costs may include

shipping costs, installation costs, or set up costs

Sunk costs are: · accounting losses on a previous business investment. · any cash outflow associated with a specific project. · previous cash outflows not relevant to the project decision.

· previous cash outflows not relevant to the project decision.

A replacement decision is one that: · replaces existing assets. · excludes relevant costs. · refinances an existing asset.

· replaces existing assets. --A replacement decision is one that replaces existing assets. Replacement projects include replacing worn out equipment, machinery, vehicles, or other assets used in the firm. The incremental cash flows from these decisions may include increased efficiency or other cost savings. There will also be an initial outlay and possibly a salvage value from selling the asset you replace.

An incremental cash flow valuation considers: · all cash inflows, but not outflows, after the investment is made. · the investment of funds before the date of the investment decision. · the additional after-tax cash flows that occur if the investment is made.

· the additional after-tax cash flows that occur if the investment is made.

An incremental cash flow valuation considers: · the additional after-tax cash flows that occur if the investment is made. · all cash inflows, but not outflows, after the investment is made. · the investment of funds before the date of the investment decision.

· the additional after-tax cash flows that occur if the investment is made.