FIN320F Unit 11
Fisher Effect
1 + Nominal Rate = (1 + Real Rate)(1 + Inflations Premium)
Inflation
A decrease in the purchasing power of a currency over a given time period. Inflation is more common in modern societies and we see prices increase over time. Primarily measured by prices (i.e. consumer price index (CPI)) and assets.
Which of the following are needed for cash flow estimation? (select multiple) A) fixed cost per unit B) unit sale per period C) selling price per unit D) variable cost per unit
B) unit sale per period C) selling price per unit D) variable cost per unit
Side effects from investing in a project refer to cash flows from: A) sunk costs B) erosion effects C) opportunity costs D) beneficial spillover effects
D) Side effects from investing in a project refer to cash flows from BENEFICIAL SPILLOVER EFFECTS
Accelerated Cost Recovery System (ACRS)
Depreciation under US tax law allowing for the accelerated write-off of property under various classifications
erosion
The cash flows of a new project that come at the expense of existing projects.
opportunity cost
The most valuable alternative that is given up if a particular investment is made.
forecasting risk (a.k.a. estimation risk)
The possibility that errors in projected cash flows will lead to incorrect decisions.
What approach does the following formula describe (T is the corporate tax rate)? OCF = (sales - costs) x (1 - T) + depreciation x T A) the sales and costs approach B) the tax shield approach C) the depreciation approach D) the depreciation shield approach
(B) the tax shield approach
What is the equation for approximating the rate of return, R? (the real rate = r and the inflation rate = h) A) R = r + h B) R = r - h C) R = r/h D) R = r x h
A) R = r + h
What is the nominal RoR on an investment? A) the RoR earned in excess of the average RoR earned by similar investments. B) the average RoR earned by similar investments. C) the percentage change in dollar value of an investment adjusted for inflation. D) the actual percentage change in dollar value of an investment unadjusted for inflation.
D) the actual percentage change in dollar value of an investment UNADJUSTED for inflation.
Free Cash Flow
the amount of cash generated by a company that is available to distribute cash to the firm's creditors and owner. This type of cash flow is not needed for short-term (working capital) or long-term (fixed asset) investments, and can be distributed to the investors—creditors and stockholders—of the firm. In our course Free Cash Flow is interchangeable with Net Cash Flow
Depreciation Tax Shield
the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate
Which of the following are fixed costs? (select multiple) A) rent on a production facility B) cost of equipment C) net working capital D) inventory costs
(A) Rent on a production and (B) cost of equipment
A positive NPV exists when the market value of a project exceeds its cost. Which of these two values is most difficult to establish? A) Both are difficult to establish B) Market value C) Project cost D) Both are easy
(B) Market value
Identify three main sources of cash flows over the life of a typical project. (select multiple) A) Net cash flows from salvage at the end of the project. B) Cash outflows from investment in plant and equipment at the inception of the project. C) Net cash flows from sales and expenses over the life of the project. D) Test marketing expenses that have been classified as sunk costs
A) Net cash flows from salvage at the end of the project. B) Cash outflows from investment in plant and equipment at the inception of the project. C) Net cash flows from sales and expenses over the life of the project.
The primary risk in estimation errors is the potential to ________. A) make incorrect capital budgeting decisions B) delay the launch of a good product C) make manager look bad
A) The primary risk in estimation errors is the potential to MAKE INCORRECT CAPITAL BUDGETING DECISIONS.
ICFAT
Incremental cash flows after taxes that occur if and ONLY if an investment project is accepted.
nominal rates
Interest rates or rates of return that HAVE NOT been adjusted for inflation.
real rates
Interest rates or rates of return that HAVE been adjusted for inflation.
Specie money
i.e. gold, silver, copper, or something else with intrinsic value.
What is Net Working Capital (NWC)? A) current assets + current liabilities B) total assets - total liabilities C) current assets - current liabilities D) total assets + total liabilities
C) current assets - current liabilities
Sunk costs are costs that ________. A) will not contribute to profits in the long run even if project is accepted B) cannot be measured C) relate to other projects of the firm D) have already occurred and are not affected by accepting or rejecting a project
D) Sunk costs are costs that HAVE ALREADY OCCURRED AND ARE NOT AFFECTED BY ACCEPTING OR REJECTING A PROJECT.
True or False: the number of positive NPV projects is unlimited for any given firm.
FALSE
In a competitive market, NPV positive projects are: A) unlimited B) uncommon C) easy to find
B) Uncommon
sunk cost
a cost we have already paid or incurred the liability to pay. Such a cost cannot be changed by the decision today to accept or reject a project.
Indirect Expenditure
an initial cash flow which results from our decision to purchase the asset; it should also be included at the project's inception.
Incremental Cash Flows
any and all changes in a firm's future cash flows that are a direct consequence of taking on the project
Mutually Exclusive Projects
Mutually exclusive projects require companies to rank (compare) competing projects and choose the best one. The previous examples used projects that had the same economic lives. However, if the project lives are not the same, then companies struggle in identifying which project is the best, and must take some additional steps in their comparison.
Stand-Alone Principle
Once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of "mini-firm" with its own future revenues, costs, assets, liabilities, and cash flows. We will then be interested in comparing the cash flows from this project/mini-firm to the cost of acquiring it.
What is the depreciation tax shield if EBIT is $600, depreciation is $1800, and the tax rate is 30%?
$1800 x 0.3 = $540
What is the model that describes the relationship bet ween the real rate r, the nominal rate R, and the inflation rate h?
(1 + R) = (1 + r)(1 + h), a.k.a. the Fisher Effect
Suppose a project's operating cash flow is $150. The firm invests $30 in NWC and $80 in capital spending. What is the project's cash flow? A) $40 B) $120 C) $170 D) $150
(A) $40
Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in _______. A) Net Working Capital (NWC) B) tax rates C) the cost of capital D) investor sentiment
A) Accounts receivable and accounts payable are included in project cash flow estimation as part of changes in NET WORKING CAPITAL.
A manager has estimated a positive NPV for a project. What could drive this result? (select multiple) A) mgmt rationality B) the project is a good investment C) the cash flow estimations are inaccurate D) overly optimistic mgmt
B) the project is a good investment C) the cash flow estimations are inaccurate D) overly optimistic mgmt
Interest expenses incurred on debt financing are ________ when computing cash flows from a project. A) treated as cash outflows B) spread over the life of the project C) ignored D) treated as cash inflows
C) Interest expenses incurred on debt financing are IGNORED when computing cash flows from a project
The first step in estimating cash flow is to determine the ___________ cash flows. A) operating B) spacious C) relevant
C) The first step in estimating cash flow is to determine the RELEVANT cash flows.
Formula for calculating Equivalent Annual Cost. Time = t, discount rate = r.
EAC = (PV x r) / (1 - (1 + r)^-t)
Operating Cash Flows
To get operating cash flows you must evaluate the operating characteristics of projects. There may be incremental investments in capital assets or changes in working capital, but the big cash flows come from producing and selling goods and services. These operating characteristics are the capital budgeting decisions. These decisions are separate from the debt and equity a company uses to raise capital. This is a capital structure decision you will see later in this course.
Direct Expenditure
an initial cash flow that is directly connected with obtaining the capital asset.
Which of the following are components of project cash flow? (multiple answers) A) Change in Fixed assets B) Operating cash flow C) Capital spending D) Change in net working capital
(B) Operating cash flow (C) Capital spending (D) Change in net working capital
The existence of inflation means we need to care about these three rates in making a decision to take on a project.
1) Nominal or stated interest rate (i.e. contractual or observed rate). 2) Real interest rate-- the real increase in purchasing power. 3) Inflation premium: investors require a premium to balance loss of purchasing power from inflation. Fisher Effect: 1 + Nominal Rate = (1 + Real Rate)(1 + Inflations Premium)
5 rules for capital budgeting
1) ONLY include cash flows in your calculations 2) Include impact of project on cash flows from other product lines (and vice versa) 3) Include all opportunity costs 4) FORGET sunk costs. Forget 'em. 5) Include only after-tax cash flows in the cash flow calculations.
An increase in depreciation expense will _______ cash flows from operations. A) increase B) decrease C) not affect
A) An increase in depreciation expense will INCREASE cash flows from operations.
Which of the following are considered relevant costs? (multiple answers) A) cash flows from erosion effects B) cash flows from external costs C) cash flows from beneficial spillover effects D) cash flows from sunk costs
A) cash flows from erosion effects B) cash flows from external costs C) cash flows from beneficial spillover effects
Exchange
An exchange is a means of facilitating economic activity.
Deflation
An increase in the purchasing power of a currency over a given time period. Deflation is feared by central bankers, as deflation lowers economic activity by increasing the real burden of debt and encouraging consumers to delay purchases.
Terminal Cash Flows
At the conclusion of a project, management will restore the company to its original condition without the project. In other words, managers must account for terminal cash flows. To do this, one must complete the following tasks: 1) Dispose of assets involved in the project. Project capital assets may have a residual value that should be included in FCF. 2) Account for changes in working capital due to the project. If a project requires a working capital investment, the firm should recover this investment. If the project frees up working capital during its life, the company must pay the cash back. 3) Account for other inflows/outflows connected to ending the project. For example, if the production process involves toxic chemicals, there may be substantial disposal costs when the project is concluded.
EBIT = $80, Depreciation = $20, taxes = $30. What is the operating cash flow (OCF)? A) $30 B) $70 C) $80 D) $20
B) $70
Which of the following statements regarding the relationship between book value, sales price, and taxes are true when a firm sells a fixed asset? (select multiple) A) Taxes are based on the difference between purchase price and sales price of the asset B) There will be a tax savings if the book value exceeds the sales price C) Book value represents the purchase price minus accumulated depreciation D) Taxes are based on the difference between book value and sales price.
B) There will be a tax savings if the book value exceeds the sales price C) Book value represents the purchase price minus accumulated depreciation D) Taxes are based on the difference between book value and sales price.
West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined the project was acceptable. Unfortunately, they lost money on the project. This may have been avoided had they assessed the _______ of the cash flow estimates. A) additivity B) reliability C) fungibility D) principality
B) West Corporation estimated cash flows for a project, evaluated those cash flows using NPV, and determined the project was acceptable. Unfortunately, they lost money on the project. This may have been avoided had they assessed the RELIABILITY of the cash flow estimates.
Operating cash flow is a function of (select multiple): A) initial investment in equipment B) taxes C) EBIT D) salvage value of equipment E) depreciation
B) taxes C) EBIT E) depreciation
Fiat money
System of currency based on nothing with intrinsic value. Leads to variable/uncertain power of purchase
True or False: NWC will be recovered at the end of a project?
True
Which of the following techniques will provide the most consistently correct result? A) Internal Rate of Return B) NPV C) Average Accounting Return D) Payback
b) NPV
Pro forma financial statements
financial statements projecting future years' operations
Though depreciation is a non-cash expense, it is important to capital budgeting for these reasons (select multiple): A) it determines the book value of assets which affects net salvage value B) it impacts product costs C) it determines taxes owed on fixed assets when they're sold D) it affects a firm's annual tax liability
A) it determines the book value of assets which affects net salvage value C) it determines taxes owed on fixed assets when they're sold D) it affects a firm's annual tax liability
What is a real rate of return? (select multiple) A) an RoR that has not been adjusted for inflation. B) an RoR that has been adjusted for inflation. C) a percentage change in buying power. D) an average RoR on similar investments
B) an RoR that has been adjusted for inflation. C) a percentage change in buying power.
Investment in net working capital occurs when.... (multiple answers) A) equipment is purchased using long-term debt B) credit sales are made C) cash is kept for unexpected expenditures D) inventory is purchased
B) credit sales are made, C) cash is kept for unexpected expenditures, D) inventory is purchased
