fin ch 10

what kind of accounting do we use?

cash based- we are interested in measuring when CFs actually actually occur, not when they accrue we are always interested in after-tax CF because taxes are definitely a cash outflow

NCS

cash flows associated with LT tangible and intangible assets of a project (PPE)

change in NWC

cash flows associated with cash on hand to smooth the current accounts

what do we not explicitly consider with MACRS?

expected salvage value and the expected economic life in the depreciation calculation

reduce of NWC is a(n)

inflow

the depreciation tax shield is an

inflow

parts of NCS

initial cost and ATSV

stand-alone principal

isolate the project and only focus on the resulting incremental cash flows assumption that the evaluation of a project may be based on the project's incremental cash flows focus on looking at a project's entire set of incremental CFs basically the logic behind thinking of projects as minifirms

what does it mean that NWC is used to smooth over current accounts

it increases when owners put cash into the business to pay the payables while waiting to sell inventory/collect AR

financing costs are a

managerial choice variable

if what goes in comes out with NWC, why do we care?

TVM

why do we have to consider changes in NWC separately?

accruals

bonus depreciation

additional depreciation allowed in the acquisition year for new tangible personal property with a recovery period of 20 years or less.

erosion

also called cannibalization the cash flows of a new project that come at the expense of a firm's existing project negative impact on the CFs of an existing product by the introduction of a new one *only relevant when the sales would not otherwise be lost think- 1:1 substitution

ATSV

also your net cash flow from an asset/net capital spending estimate of an asset's after-tax value salvage - t(salvage-book) be mindful if it is a refund/payment

what do we use the CFFA for?

applying chapter 9 tools to evaluate if the project creates or destroys value

different ways to calculate OCF

bottom-up top-down tax shield

general flow of this whole process

calculate projected sales compute depreciation make pro forma income statements find OCF find changes in NWC (and see when you recover it) find NCS by the initial investment and ATSV add them all together and use CFFA to see if it creates value

why can't you compare assets with different lives?

the short-lived asset is missing replacement costs that the firm will incur when the asset dies

NWC with noncash transactions

to get actual cash flow, you must adjust for the discrepancy between accounting/actual sales and costs (which NWC does) revenue: change in cash sales- change in AR (need to subtract from OCF) costs: change in cash costs - change in AP/inventory (need to add to OCF) together: OCF - change in NWC

CFFA

total net cash flow per period associated with a project stream of cash inflows/outflows generated by the firm's assets at every point it time, it's OCF-change NWC-NCS used when using chapter 9 tools

Sunk costs are costs that accrued in the past and irrelevant.

true

w/ replacement problems, you still need to take ______ into account

ATSV (now and at end of life)

Taxes

EBIT x tax rate

Depreciation is a non-cash expense that is an incremental cash flow.

False

Net working capital creates incremental cash flows and therefore should be included when applying the stand alone principle.

False

why is the stand alone principle important?

Important because it's saying that you're only taking into account the cash flows that will affect this project- putting the costs in "isolation"

difference between net working capital and net capital spending

NCS you won't get back but you should recover NWC

finding EAC

NPV of costs use 3rd row keys to find payment (I/Y is required return, N is life of project, NPV is PV, calculate PMT) PV of costs x annuity factor want a lower EAC or less negative

CFFA equation

OCF - change in NWC - NCS

tax shield approach

OCF = (Sales - Costs)(1 - T) + Depreciation*T first half represents the CFs w/o depreciation expense (after tax gross profit) second part is the depreciation tax shield *use with MACRS

generic OCF logic

OCF = EBIT + Depreciation - Taxes

bottom-up approach

OCF = Net income + depreciation (NI is EBIT-Taxes) *only works w/o interest expense start with net income at bottom of IS then add back any noncash items (depreciation/amortization)

top-down approach

OCF = Sales - Costs - Taxes *only works w/o interest expense start with sales on top of IS then go down subtracting costs and taxes

sources of the 3 parts of CFFA

OCF: IS change in NWC: BS NCS: BS

EBIT

Sales - Costs - Depreciation

mid-year convention

The practice of using June 30 as the accounting date for a cash flow when an analyst does not have the exact details of the cash flow over the year

Costs to other projects from the introduction of a new project are negative side effects that create incremental cash flows.

True

Depreciation and amortization are accrual accounting allocation schemes that can indirectly impact a project's incremental cash flows.

True

If the introduction of the newest iPhone hurts the sales of the last version, only part of the lost sales is incremental because Apple would probably lose some of those sales to the introduction of a new Galaxy phone by Samsung.

True

The cash flow from assets is the total net cash flow per period associated with a project.

True

The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows.

True

The time already expended on an endeavor is a sunk cost.

True

We only care about the non-cash expense called depreciation in so far as it can change a project's taxes.

True

You extract the changes in net working capital from the proforma balance sheets.

True

You extract the net capital spending from the proforma balance sheets.

True

sunk costs

a cost we have already paid/incurred the liability to pay and cannot be removed

accelerated cost recovery system (ACRS)

a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications governs the way that depreciation is computed for tax purposes

changes in net working capital

change in CA - change in CL investments other than LTA often resembles a loan that the firm can recover the majority of

relevant cash flow

change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project only occur if, and only if, the project is accepted

straight line depreciation

cost includes all costs same rate each year AD climbs to initial cost

steps of capital budgeting

create pro forma financial statements extract CFs from pro formas use capital budgeting decision rules to ultimately decide whether to accept or reject the project

NWC

current assets - current liabilities

when extracting information from the pro forma statements, what is the ultimate goal?

determine CFFA

what is the first and most important step when using pro forma financial statements

determine which CFs are relevant to the project

book value versus market value

economic life and future market value of the asset is not an issue BV can differ substantially from its actual market value

salvage value

estimated market value of an asset at the end of its useful life

Modified ACRS Depreciation (MACRS)

every asset is assigned to a particular class that establishes its life for tax purposes then compute depreciation by multiplying the cost of the asset by a fixed % all of the MACRS percentages sum up to 100% *note that land cannot be depreciated immediately gets bigger in second period then tapers off depreciates entire cost over life so BV is 0 at end

side effects

externalities can be positive (benefits to other projects, think of Apple) or negative (think of oatmeal) impacts, both good and bad, a new project has on the incremental cash flows of other existing lines of business

T/F: after-tax CF and net income are the same thing

false

We only care about the non-cash expense called amortization in so far as it can change a project's cost of goods sold.

false

when you have an outflow, your balance sheet

goes up (nothing to something or something to nothing) ex: you're writing a check (outflow) but you're getting cash, making the BS go up

logic behind why we don't include financing costs

how we pay for the cash flows doesn't change the actual cash flows/affect the CFs directly associated with the assets we are evaluating

if part of a cash flow will occur only if we accept the project, do we include it?

include the part that occurs because of the project

cost of lost options

negative side effect

how is a finance balance sheet different than accounting

no LT liabilities, common stock, or retained earnings because they are all financing costs we only use CA/CL/LTA

depreciation

noncash deduction that has CF consequences only because it influences the tax bill

when does a capital gain occur?

only if the market price exceeds the original cost

3 parts of Cash Flows from Assets

operating cash flow, capital spending, and changes in net working capital

changes in NWC affect

opportunity cost

common CFs

opportunity costs, side effects, changes in NWC, taxes

when you have to pay extra taxes, the asset is

overdepreciated too much was taken earlier (resulting in tax shields that are too big_

pro forma financial statements

pro forma means forecasted or projected and we need these statements to develop the projected cash flows of a project project future years' operations includes sales, cost, depreciation, taxes, etc. but NOT interest expense

capital budgeting

process by which forms allocate their scarce capital for future long-term projects

EAC

provides average cost per period (opposed to total cost) but appropriately adjusts for the TVM also called equivalent annual annuity necessary when the possibilities under evaluation have different economic lives and we will need whatever we buy more or less indefinitely

things to include in NWC

receivables, inventory, cash ending-beginning in these categories

OCF

regularly generated CFs from the ongoing activities from the project

what is an example of a NWC outflow at the end of a project?

restocking invenntory

in practice, what's going in is

retained earnings

common things on the IS

revenue, COGS, SGA, Depreciation = EBIT Taxes Net Income

depreciation tax shield

tax saving that results from the depreciation deduction the only CF effect of deducting depreciation is reducing our taxes, as it is a noncash expense savings is amount of depreciation(marginal tax rate)

taxes when asset is sold before it fully depreciates

taxes must be paid/refunded based on the difference between the market value and book value If market value > BV, you have to pay If market value < BV, you get the tax incentive this is NOT a capital gain

incremental cash flow

the difference between a firm's future cash flows with a project and those without the project any and all changes in the firm's future cash flows that are a direct consequence of taking the project

NWC use

the money you use to smooth over accounts

opportunity costs

the most valuable alternative that is given up if a particular investment is undertaken the benefit you are given up

marketing is a sunk cost

true

evaluating cost-cutting proposals

use tax shield approach

financing costs

we do not include interest paid or financing costs (dividends, principals repaid) because we are interested in the CF generated by the assets of the project these are important, just something to be analyzed separately

disadvantage of the stand-alone principal

we evaluate the projects only in their own merits with nothing to do with any other activities or projects