Chapter 9 - Corporate Finance

Any changes to a firm's projected future cash flows that are caused by adding a new project are referred to as:

incremental cash flows.

The primary risk in estimation errors is the potential to __________.

make incorrect capital budgeting decisions

An option on a real asset rather than a financial asset is known as a:

managerial option real option

The difference between a firm's current assets and its current liabilities is known as the _____.

net working capital

True or false: In calculating cash flows, you should consider all financing costs.

False In analyzing a proposed investment, you should not include interest paid or any other financing costs.

The Blue Lagoon is considering a project with a five-year life. The project requires $32,000 of fixed assets that are classified as five-year property for MACRS. Variable costs equal 67 percent of sales, fixed costs are $12,600, and the tax rate is 34 percent. What is the operating cash flow for Year 4 given the following sales estimates and MACRS depreciation allowance percentages? (There is also a chart that didn't copy.)

$1,409.80

Dismal Outlook is unable to obtain financing for any new projects under any circumstances. This company is faced with:

hard rationing.

If we find that our estimated NPV is sensitive to a variable that is difficult to forecast, then the degree of forecasting risk is _____.

high

Interest expenses incurred on debt financing are ______ when computing cash flows from a project.

ignored

Synergy will _____ the sales of existing products

increase

Sunk costs are costs that ____.

have already occurred and are not affected by accepting or rejecting a project

To investigate the impact on NPV of a change in one variable, you would employ ________.

sensitivity analysis

Broadband, Inc., has estimated preliminary cash flows for a project and found that the NPV for those cash flows is $400,000. The company now plans to perform a scenario analysis on the cash flow and NPV estimates. It will use an NPV of _____ as the base case.

$400,000

What are the two main drawbacks of sensitivity analysis?

-It does not consider interaction among variables. -It may increase the false sense of security among managers if all pessimistic estimates of NPV are positive. -It is not easy to compute

What are the two main benefits of performing sensitivity analysis?

-It reduces a false sense of security by giving a range of values for NPV instead of a single value. -It identifies the variable that has the most effect on NPV.

Which of the following qualify as "managerial options"?

-The option to abandon -The option to expand -The option to wait

Investment in net working capital arises when ____.

-inventory is purchased -cash is kept for unexpected expenditures -credit sales are made

If a firm's sales estimate used in its base case analysis is 1,000 units per year and they anticipate the upper and lower bounds to be +/- 15%, What is the "best case" for units sold per year?

1,150 Reason: 1.15 × 1,000 = 1,150

If a new project requires an investment in net working capital when it is launched, then at the end of the project, NWC will be

100% reversed.

The rules for depreciating assets for tax purposes are based upon provisions in the:

1986 Tax Reform Act

Phil's Dinor purchased some new equipment two years ago for $32,600. Today, it is selling this equipment for $22,000. What is the aftertax cash flow from this sale if the tax rate is 35percent? The applicable MACRS allowance percentages are as follows, commencing with Year 1: 20.00, 32.00, 19.20, 11.52, 11.52, and 5.76 percent.

After tax cash flow = $22,000 - {[$22,000 -32,600 ×(1 - .20 -.32)] ×.35} = $19,776.80

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 are considered relevant cash flows?

Cash flows from external costs Cash flows from erosion effects Cash flows from beneficial spillover effects

True or false: Sensitivity analysis is helpful because it indicates what we should do regarding forecasting errors.

False Sensitivity analysis does not tell us what to do about forecasting errors.

True or false: Taxes are based on the difference between the initial cost and the sales price.

False Taxes are based on the difference between the book value and the sales price.

True or false: The depreciation tax shield is the depreciation deduction divided by the tax rate.

False The depreciation tax shield is the depreciation deduction times the tax rate.

An increase in depreciation expense will ____ cash flows from operations.

Increase Because depreciation is not a cash expense, its only effect is to decrease taxes paid, thereby increasing cash flows from operations.

Which of the following create cash inflows from net working capital?

Increase in accounts payable and decrease in inventory

Which of the following are reasons why NPV is considered a superior capital budgeting technique?

It considers all the cash flows. It considers time value of money. It considers the riskiness of the project. It properly chooses among mutually exclusive projects

In the context of capital budgeting, what does sensitivity analysis do?

It examines how sensitive a particular NPV calculation is to changes in underlying assumptions.

Mike's Fish Market is implementing a project that will initially increase accounts payable by $6,100, increase inventory by $2,800, and decrease accounts receivable by $1,300. All net working capital will be recouped when the project terminates. What is the cash flow related to the net working capital for the last year of the project?

Net working capital recovery = -$6,100 + 2,800 -1,300 = -$4,600

Floral Shoppes has a new project in mind that will increase accounts receivable by $19,000, decrease accounts payable by $4,000, increase fixed assets by $27,000, and decrease inventory by $2,000. What is the amount the firm should use as the initial cash flow attributable to net working capital when it analyzes this project?

Net working capital requirement = -$19,000 - 4,000 + 2,000 = -$21,000

Which of the following is the equation for estimating operating cash flows using the tax shield approach?

OCF = (Sales - Costs) × (1 - Tax rate) + Depreciation × Tax rate

Which of the following are components of project cash flow? Operating cash flow Capital spending Change in net working capital Change in Fixed assets

Operating cash flow Capital spending Change in net working capital

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

Lee's currently sells 13,800 motor homes per year at $87,900 each, and 1,100 luxury motor coaches per year at $139,900 each. The company wants to introduce a low-range camper to fill out its product line; it hopes to sell 7,200 of these campers per year at $17,500 each. An independent consultant has determined that if the company introduces the new campers, it should boost the sales of its existing motor homes by 1,100 units per year, and reduce the sales of its luxury motor coaches by 610 units per year. What amount should be used as the annual sales figure when evaluating this project?

Sales = (1,100 ×$87,900) + (-610 ×$139,900) + (7,200 ×$17,500) = $137,351,000

What is the difference between scenario analysis and sensitivity analysis?

Scenario analysis considers a combination of factors for each scenario while sensitivity analysis focuses on only one variable at a time.

What is scenario analysis? Scenario analysis determines the impact on NPV of a change in a single variable. Scenario analysis determines the probability of occurrence of various future events that could affect the project. Scenario analysis maps out the various steps involved in the manufacturing process. Scenario analysis determines the impact on NPV of a set of events relating to a specific scenario.

Scenario analysis determines the impact on NPV of a set of events relating to a specific scenario.

A manager has estimated a positive NPV for a project. What could drive this result? The project is a good investment. Overly optimistic management Management rationality The cash flow estimations are inaccurate.

The project is a good investment. Overly optimistic management The cash flow estimations are inaccurate.

Six years ago, China Exporters paid cash for a new packaging machine that cost $347,000. Three years ago, the firm spent $14,300 on repairs and modifications to the machine. The machine is now fully depreciated and has just sat idly in a back corner of the shop for the past seven months. The estimated value of the machine today is $157,500. The firm is considering using this machine in a new project. If it does so, what value should be assigned to this machine and included in the initial costs of the new project?

The relevant cost is the opportunity cost of $157,500.

To prepare proforma financial statements, estimates of quantities such as unit sales, selling price per unit, variable cost per unit, and total fixed costs are required.

True

True or false: If analysts are overly optimistic about the future, then they may accept a project that realistically has a negative NPV.

True

True or false: Investment in net working capital may arise from the need to cover credit sales.

True

True or false: While performing sensitivity analysis, we recompute NPV several times by changing one input variable at a time.

True

Cash flows should always be considered on a(n) ___________ basis.

after-tax

Cash flows used in project estimation should always reflect: accounting values after-tax cash flows financing costs cash flows when they occur

after-tax cash flows cash flows when they occur

The goals of risk analysis in capital budgeting include:

assessing the degree of financing risk identifying critical components

Side effects from investing in a project refer to cash flows from: sunk costs beneficial spillover effects erosion effects opportunity costs

beneficial spillover effects erosion effects

Opportunity costs are ____.

benefits lost due to taking on a particular project

The most valuable alternative that is given up if an investment is undertaken is called what?

opportunity cost

Once cash flows have been estimated, which of the following investment criteria can be applied to them? YTM payback period IRR the constant growth dividend discount model NPV

payback period IRR NPV

Given a level of investment in net working capital, that same investment must be _____at some time in the future.

recovered

Erosion will ______ the sales of existing products.

reduce

Opportunity costs are classified as ____ costs in project analysis.

relevant

West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined that the project was acceptable. Unfortunately West Corporation lost money on the project. This may have been avoided had they assessed the ______ of the cash flow estimates.

reliability

When using _______________, all of the variables except one are frozen in order to determine how sensitive the NPV estimate is to changes in that particular variable.

sensitivity analysis

The depreciation tax _____ is the tax savings that results from the depreciation deduction.

shield

The amount by which a firm's tax bill is reduced as a result of the depreciation expense is referred to as the depreciation:

tax shield.

Capital rationing exists when a company has identified positive NPV projects but cannot (or will not) find:

the necessary financing

If a firm's variable cost per unit estimate used in its base case analysis is $50 per unit and they anticipate the upper and lower bounds to be +/- 10%, What is the "worst case" for variable cost per unit?

$55= 1.10*50 Reason: 1.10 × $50 = $55; The worst case for costs is the higher value.

Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons: it determines the book value of assets which affects net salvage value it impacts product costs it determines taxes owed on fixed assets when they are sold it affects a firm's annual tax liability

-it determines taxes owed on fixed assets when they are sold -it affects a firm's annual tax liability -it determines the book value of assets which affects net salvage value

Which of the following is true relative to capital rationing?

-soft rationing is typically internal in that the firm allocates funds to divisions for capital projects -hard rationing implies the firm is unable to raise funds for projects

Western Steer purchased some three-year MACRS property three years ago. What is the current book value of this equipment if the original cost was $94,250? The MACRS allowance percentages are as follows, commencing with Year 1: 33.33, 44.45, 14.81, and 7.41 percent.

Book value3 = $94,250 ×(1 - .3333 - .4445 - .1481) = $6,983.93

A project has sales of $511,800, costs of $322,400, depreciation of $22,620, interest expense of $3,062, and a tax rate of 34 percent. What is the value of the depreciation tax shield?

Depreciation tax shield = $22,620 ×.34 = $7,690.80

Flo is considering three mutually exclusive options for the additional space she plans to add to her specialty women's store. The cost of the expansion will be $148,000. She can use this additional space to add children's clothing, an exclusive gifts department, or a home décor section. She estimates the present value of the cash inflows from these projects are $121,000 for children's clothing, $178,000 for exclusive gifts, and $145,000 for decorator items. Which option(s), if any, should she accept?

Exclusive gifts only

True or false: Fixed costs cannot be changed over the life of the investment.

False Fixed costs cannot be changed in the short term but can be changed over the long term.

True or false: Operating cash flow is based on the salvage value of equipment.

False Operating cash flow equals EBIT plus depreciation minus taxes

True or false: The value of managerial options is taken into account when performing conventional NPV analysis.

False The value of managerial options is ignored when conducting conventional NPV analysis.

The number of positive NPV projects is unlimited for any given firm.

False The positive NPV investments are not at all common and the number of positive NPV projects is certainly limited for any given firm.

What is an important drawback of traditional NPV analysis?

It ignores managerial options in investment decisions.

The Sausage Hut is looking at a new sausage system with an installed cost of $187,400. This cost will be depreciated straight-line to zero over the project's four-year life, at the end of which the sausage system can be scrapped for $25,000. The sausage system will save the firm $69,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $9,000, which will be recouped at project end. If the tax rate is 34 percent and the discount rate is 12 percent, what is the NPV of this project?

OCF = $69,000 (1 - .34) + ($187,400 /4)(.34) = $61,469 NPV = -$187,400 -9,000 + ($61,469 ×{1 - [1 / (1 + .12)^4]} / .12) + {$9,000 + [$25,000 × (1 - .34)]} / (1 + .12)^4 NPV = $6,508.54

A nine-year project is expected to generate annual revenues of $137,800, variable costs of $82,600, and fixed costs of $11,000. The annual depreciation is $23,500 and the tax rate is 34 percent. What is the annual operating cash flow?

Operating cash flow = ($137,800 -82,600 -11,000) ×(1 -.34) + ($23,500 ×.34) = $37,162

_____ analysis is useful in pinpointing variables that deserve the most attention.

Sensitivity

Kate is analyzing a proposed project to determine how changes in the sales quantity would affect the project's net present value. What type of analysis is being conducted?

Sensitivity analysis

Green Woods sells specialty equipment for mountain climbers. Its sales for last year included $387,000 of tents and $718,000 of climbing gear. For next year, management has decided to sell specialty sleeping bags also. As a result of this change, sales projections for next year are $411,000 of tents, $806,000 of climbing gear, and $128,000 of sleeping bags. How much of next year's sales are derived from the side effects of adding the new product to its sales offerings?

Side effects = ($411,000 + 806,000) - ($387,000 + 718,000) = $112,000

Which one of the following principles refers to the assumption that a project will be evaluated based on its incremental cash flows?

Stand-alone principle

True or false: Net working capital will be recovered at the end of a project.

True On a purely mechanical level, notice that whenever we have an investment in net working capital, that same investment has to be recovered.

Which of the following are fixed costs? inventory costs net working capital cost of equipment rent on a production facility

cost of equipment rent on a production facility

What is net working capital?

current assets minus current liabilities

The possibility that errors in projected cash flows will lead to incorrect decisions is known as:

estimation risk forecasting risk

We underestimate NPV because of the option(s) to ______.

expand abandon

The Shoe Box is considering adding a new line of winter footwear to its product lineup. When analyzing the viability of this addition, the company should include all of the following in its analysis with the exception of:

the research and development costs to produce the current winter footwear samples.

Identify the three main sources of cash flows over the life of a typical project.

-Net cash flows from salvage value at the end of the 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

Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset?

-There will be a tax savings if the book value exceeds the sales price. -Taxes are based on the difference between the book value and the sales price. -Book value represents the purchase price minus the accumulated depreciation.

A positive NPV exists when the market value of a project exceeds its cost. Which of these two values is the most difficult to establish?

Market value

A project has an initial requirement of $318,000 for fixed assets and $29,500 for net working capital. The fixed assets will be depreciated to a zero book value over the four-year life of the project and have an estimated salvage value of $110,000. All of the net working capital will be recouped at the end of the project. The annual operating cash flow is $96,200 and the discount rate is 14 percent. What is the project's net present value if the tax rate is 34 percent?

NPV = -$318,000 - 29,500 + ($96,200× {1 - [1 / (1.14)^4]} / .14) + [$29,500 + $110,000 ×(1 - .34)] / 1.14^4) NPV = -$6,749.48

Industrial Services is analyzing a proposed investment that would initially require $489,000 of new equipment. This equipment would be depreciated on a straight-line basis to a zero balance over the four-year life of the project. The estimated salvage value is $135,000. The project requires $32,000 initially for net working capital, all of which will be recouped at the end of the project. The projected operating cash flow is $174,900 a year. What is the internal rate of return on this project if the relevant tax rate is 35 percent?

NPV = 0 = -$489,000 - 32,000 + ($174,900 ×{ 1 - [1 / (1 + IRR)^4]} / IRR) + {$32,000 + [$135,000 ×(1 - .35)]} / (1 + IRR)^4 IRR = 19.02 percent

Which of the following techniques will provide the most consistently correct result? Average Accounting Return Payback Net Present Value Internal Rate of Return

Net Present Value

Three years ago, Stock Tek purchased some five-year MACRS property for $82,600. Today, it is selling this property for $31,500. How much tax will the company owe on this sale if the tax rate is 34 percent? The MACRS allowance percentages are as follows, commencing with Year 1: 20.00, 32.00, 19.20, 11.52, 11.52, and 5.76 percent.

Tax on salvage value = [$31,500 - $82,600 ×(1 - .20 -.32 - .192)] ×.34 = $2,621.81

Operating cash flow is a function of: Taxes Earnings Before Interest and Taxes Salvage Value of Equipment Depreciation Initial Investment in Equipment

Taxes Earnings Before Interest and Taxes Depreciation

The Corner Market has decided to expand its retail store by building on a vacant lot it currently owns. This lot was purchased four years ago at a cost of $299,000, which the firm paid in cash. To date, the firm has spent another $38,000 on land improvements, all of which was also paid in cash. Today, the lot has a market value of $329,000. What value should be included in the analysis of the expansion project for the cost of the land?

The current market value of the land

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

The project cash flow equals the project operating cash flow _________ project change in NWC minus project capital spending.

minus

Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in ______________.

net working capital

In a competitive market, positive NPV projects are:

uncommon

In order to analyze the risk of a project's NPV estimate, we should establish ___________ for each important estimate variable.

upper and lower bounds

The basic approach to evaluating cash flow and NPV estimates involves asking:

what-if questions

The Green Tomato purchased a parcel of land six years ago for $389,900. At that time, the firm invested $128,000 grading the site so that it would be usable. Since the firm wasn't ready to use the site itself at that time, it decided to lease the land for $48,000 a year. The Green Tomato is now considering building a hotel on the site as the rental lease is expiring. The current value of the land is $415,000. The firm has no loans or mortgages secured by the property. What value should be included in the initial cost of the hotel project for the use of this land?

The relevant cost is the opportunity cost of $415,000.

A positive NPV exists when the market value of a project exceeds its cost. Unfortunately, most of the time the market value of a project:

cannot be observed

The pro forma income statements for a proposed investment should include all of the following except: fixed costs. forecasted sales. depreciation expense. taxes. changes in net working capital.

changes in net working capital.

Managerial options are taken into consideration in _____ planning.

contingency

When we estimate the best-case, worst-case, and base-case cash flows and calculate the corresponding NPVs, we are engaging in:

scenario analysis asking what-if questions

Estimates of which of the following are needed to prepare pro forma income statements? selling price per unit historical trends unit sales competitor pricing variable costs

selling price per unit unit sales variable costs

Scenario analysis considers a combination of factors for each scenario while _____ analysis focuses on only one variable at a time.

sensitivity