Financial Accounting 7.0: Accounting for the Future | HBS CORe

Which of the following statements is NOT true in relation to the Gordon Growth Model? Terminal value is the present value of infinite cash flows expected in the future. A higher discount rate results in a higher terminal value. The Gordon Growth Model assumes that the growth rate will remain fixed. A higher growth rate results in a higher terminal value.

A higher discount rate results in a higher terminal value. This statement is not true. A higher discount rate results in a lower terminal value.

Which of the following statements is NOT true regarding payback periods? A payback period is the length of time required to recover the cost of an investment. A shorter payback period is preferable to a longer payback period. A payback period is impacted by cash flows that occur after the initial cost is recovered. A payback period ignores the time value of money.

A payback period is impacted by cash flows that occur after the initial cost is recovered. This is the correct answer! This statement is NOT true. Payback Period only considers cash flows that occur before the initial cost is recovered and ignores any cash flows that occur after the payback period.

Next, based on the calculations above, let's build the financial statement to reflect this operating lease. To simplify the case, assuming there is no tax and gross profit at a constant $650,000/year. Please fill in the Lease Liability and Lease Expense in the spreadsheet below.

Annual straight-line lease expense = sum(C3:G3)/5 = ($150+$155+$159+$163+$167)/5 = $159 Lease liability = PV of Remaining Future Lease Payments

FCF

FCF = (1-t) x EBIT + Dep - Capx - D NWC where t is the tax rate, Dep is depreciation expense, Capx is capital expenditures and D NWC is the change in net working capital

How to find EBIT

Starting with the bottom line, net income, we add back the interest expense and income taxes expense lines. The result is EBIT.

Which of the following is INCORRECT in determining free cash flows? Adjust net income for interest expense Subtract capital expenditures Subtract depreciation Subtract change in working capital

Subtract depreciation This is the correct answer! It is NOT true. You ADD BACK depreciation in determining free cash flows.

Given that ELC's discount rate is 0.7 percent, what is the present value of future lease payments upon lease commencement? (in thousands of dollars) $760 $777 $1,001 $870

Suppose the commencement of the lease is at time 0. Since each year's payment varies, we can use the NPV spreadsheet formula to calculate the PV of inconsistent cash outlays. PV of future lease payments = NPV (B3, C2:G2) = $777

A project has a negative NPV. Which of the following statements is true regarding this project? The project will not yield any positive cash flows in the future. The sum of undiscounted cash flows is negative. The IRR of the project is negative. The IRR of the project is less than the WACC.

The IRR of the project is less than the WACC. This is the correct answer! IRR is the discount rate at which the net present value of an investment equals zero. Therefore: When NPV < 0, IRR < WACC. When NPV = 0, IRR = WACC. When NPV > 0, IRR > WACC.

Which of the following cash flows should be used in an NPV calculation to determine which project to pursue? (Select all that apply.) The cash inflows expected as a result of the project Recurring cash flows from ongoing current operations Investment needed to be made by the company to undertake the project Capital expenditures related to upkeep of existing equipment

The cash inflows expected as a result of the project - This is correct! It is an incremental cash flow that would only be received if the project were undertaken. Investment needed to be made by the company to undertake the project - This is correct! It is an incremental cash flow that would only be incurred if the project is undertaken.

Weighted Average Cost of Capital (WACC)

The discount rate which represents the cost to the business of raising funds. This rate will vary from one business to the next, but is the discount rate that many companies use in the NPV calculation. If a project or investment cannot return more than the WACC, the company would lose money on the investment.

TVM equation

The fundamental equation underlying the time value of money concept is: FV = PV x (1 + i)n or PV = FV / (1+i)n Where: FV = Future value PV = Present value i = Interest rate per period N = Number of periods

Terminal Value

The present value of a stream of funds that extend into the indefinite future. See also Gordon Growth Model for a formula that may be used to calculate terminal value. Terminal Value = CF / (r − g) where CF = cash floe r = discount rate g = growth rate

Suppose you are considering buying a machine that costs $7,000. Three years from now, it is expected to require an upgrade that will cost $2,500. It will generate net cash flows of $1,500 for the next 8 years. If your discount rate is 8 percent, what is the NPV of this investment? The present value of $1 for 3 years at 8 percent is 0.79383 The present value of an ordinary annuity of $1 for 8 years at 8 percent is 5.74664

To solve this problem, we must think of each cash flow stream. There is an initial cash outflow of $7,000. Because this will occur now, the present value of this is −$7,000. There is a cash outflow of $2,500 that will occur three years from now. The present value is calculated as −$2,500 × 0.79383 = −$1,985 There is an annuity of cash inflows of $1,500 each year for 8 years. The present value is calculated as $1,500 × 5.74664 = $8,620 Thus, the NPV is the sum of each of these present values. −$7,000 − $1,985 + $8,620 = −$365 The NPV of the investment is −$365. Because the NPV is negative, it means the sum of the discounted cash inflows is less than the sum of the discounted cash outflows, so the company should not invest in the machine because it would receive a return that is less than the discount rate.

Operating vs. Finance Leases

Two types of leases are operating leases and finance (previously capital) leases. To differentiate between the two, we need to consider five questions: - Does the lease transfer asset ownership to the lessee by the end of the lease term? - Does the lease grant the lessee an option to purchase the underlying asset that the lessee is reasonably certain to exercise? - Is the lease term for a major part of the remaining economic life of the underlying asset? - Is the present value of the sum of the lease payments and any residual value guaranteed by the lessee, that is not otherwise included in the lease payments, substantially all of the fair value of the underlying asset? - Is the underlying asset of such a specialized nature that it is expected to have no alternative use to the lessor at the end of the lease term? If a lessee answered "yes" to any of the questions above, they are holding a finance lease; if the answer was "no" for all five questions, then the lease should be classified as an operating lease.

Types of leases

operating leases and financing leases

Adele's Deli had the following account balances as of December 31, 2020: Accounts Receivable$1,200 Accumulated Depreciation$200 Inventory$500 Building$2,000 Equipment$500 Accounts Payable$300 Salaries/Wages Payable$900 Which of the following represents the net working capital for the business? $500 $1,300 $1,100 $1,500

$500 Current assets (excluding cash for the purposes of calculating free cash flows) minus current liabilities equals net working capital. In this case, current assets total $1,700 (accounts receivable and inventory), and current liabilities (accounts payable and salaries payable) total $1,200. The difference, the net working capital, is $500.

Let's assume Estée Lauder entered into a five-year operating lease on January 1, 2021, for the new store in Chicago. They agree to pay $150,000 in year 1, $155,000 in year 2, $159,000 in year 3, $163,000 in year 4, $167,000 in year 5. Payments will be made at the end of each year. First, calculate the ELC's annual straight-line lease expense. (in thousands of dollars, round to the nearest integer)

($150K + $155K + $159K + $163K + $167K)/5 = $159K

1) Record straight-line amortization expense and adjust the ROU asset accordingly. 2) Record interest expense and reduction in principal for lease liability.Rounding to the nearest integer (in $ thousands).

(in $ thousands) 1) Record straight-line amortization expense and adjust the ROU asset accordingly Answer: Amortization Expense = ROU Asset = $777/5 = $155.4 ($155) 2) Record interest expense and reduction in principal for lease liability Answer: Interest Expense = ($777 − $144.6 − $150.6 − $155.6 − $160.7) × 0.7% = $1.2 ($1) Cash = Lease Payment = $167 $167 − ($777 − $144.6 − $150.6 − $155.6 − $160.7) × 0.7% = $165.8 ($166)

1) Record straight-line amortization expense and adjust the ROU asset accordingly. 2) Record interest expense and reduction in principal for lease liability.Rounding to the nearest integer (in thousands of dollars.)

(in thousands of dollars) 1) Record straight-line amortization expense and adjust the ROU asset accordingly Answer: Amortization Expense = ROU Asset = $777/5 = $155.4 ($155) 2) Record interest expense and reduction in principal for lease liability Answer: Interest Expense = ($777 − $144.6 − $150.6) × 0.7% = $3.4 ($3) Cash = Lease Payment= $159 Finance Lease Liability = $159 − ($777 − $144.6 − $150.6) × 0.7% = $155.6 ($156)

1) Record straight-line amortization expense and adjust the ROU asset accordingly. 2) Record interest expense and reduction in principal for lease liability.Rounding to the nearest integer (in thousands of dollars.)

(in thousands of dollars) 1) Record straight-line amortization expense and adjust the ROU asset accordingly Answer: Amortization Expense = ROU Asset = $777/5 = $155.4 ($155) 2) Record interest expense and reduction in principal for lease liability Answer: Interest Expense = ($777 − $144.6 − $150.6 − $155.6) × 0.7% = $2.3 ($2) Cash = Lease Payment = $163 Finance Lease Liability = $163 − ($777 − $144.6 − $150.6 − $155.6) × 0.7% = $160.7 ($161)

Calculating IRR: Using a spreadsheet

=IRR(values) Values is an array of numbers for which to calculate the internal rate of return. Values must contain at least one positive value and one negative value. The order of values must be in the order of cash flows.

Calculating Net Present Value: Using a Spreadsheet

=NPV(rate,value1,value2, ...) Rate is the interest rate (also known as the discount rate) for the period. Value1, value2, ... are equally spaced cash flows that occur at the end of each period. There is one important thing to note about using the NPV formula. The formula itself does not include any cash flow at time 0 (today). Instead, the formula takes into account all future cash flows and nets them back to the present value today, so if there are any cash flows at time 0 (today), those must be added or subtracted separately outside of the NPV formula.

Present Value Equation

=PV(rate,nper,pmt) Rate is the interest rate (also known as discount rate) for the period. Nper is the number of payment periods for the given cash flow. Pmt is the payment, or cash flow, to be discounted.

An equipment rental company leased a piece of equipment on the first of January and agreed to receive an annual rental fee of $12,000 at the end of each of the next 15 years. The discount rate of the company is 7.5 percent. What is the present value of the rental payments over 15 years?

=PV(rate,nper,pmt) The correct answer is -$105,925. The correct answer formula is: =PV(E4,E5,E6) where # Periods (E5) is 15, and Pmt Amount (E6) is 12,000. Notice that the PV formula makes the answer negative. This is because it represents the amount you would be willing to pay today to receive the given cash flows. You would be willing to pay this amount because it is equivalent to the amount you will receive, so the net amount you pay and receive will be zero. So, if your discount rate is 7.5 percent, you would be willing to pay $105,925 for equipment that would provide this stream of rental income over the next 15 years.

Example: A company is considering investing in a new project with infinite life. The estimated cash flows of the first three years of the project are shown as follows: 2021: $1000 2022: $1500 2023: $2000 After 2023, the annual cash flow of the project is expected to stabilize at about 2 percent growth. The discount rate is 5 percent. What is the Terminal Value of the project on January 1, 2024?

Because cash flow is expected to grow at a stable rate of 2 percent after 2023, we can calculate the cash flow of 2024, the first year of the stabilized period, as $2,000 × 1.02 = $2,040. According to the Gordon Growth Model: Terminal Value = CF / (r − g) = $2,040 / (5% − 2%) = $68,000 So the terminal value of the project on January 1, 2024 is $68,000.

Free cash flows

Cash flows that are free, or available, to distribute to investors or to reinvest in the business after the business has covered all its expenses. FCF does not consider the impact of how a business is financed. Calculated by the formula: FCF = (1-t) * EBIT + Depreciation - Capital Expenditures - Change in Net Working Capital.

Adele's Deli had the following account balances as of December 31, 2019: Accounts Receivable$500 Inventory$1,250 Accounts Payable$200 Salaries/Wages Payable$225 They had the following account balances as of December 31, 2020: Accounts Receivable$900 Inventory$1,000 Accounts Payable$400 Salaries/Wages Payable$100 Which of the following represents the change in net working capital from 2019 to 2020? 1,325 1,250 75 100

Change in Net Working Capital is calculated for the purposes of arriving at free cash flows as the current year's net of current assets (excluding cash) and current liabilities less the prior year's net of current assets and current liabilities. The net working capital for 2020 was $1,400. The net working capital for 2019 was $1,325. The difference, the change in net working capital, is 75.

Net working capital (NWC)

Current Assets - Current Liabilities. Positive when cash that will be available over the next 12 months is greater than the cash that must be paid over that period refers to the business having cash tied up in operations. As the business grows, it will typically need more cash to fund day-to-day operations. This is cash that will be dedicated to the business and won't be available for other purpos

In our formula, FCF = (1-t) x EBIT + Dep - Capx - Δ NWC ________ is another name for the bolded portion: (1-t) x EBIT

EBIAT - Earnings Before Interest After Taxes

Which of the following statements are true? Select all that apply. EBIT equals EBIAT if there is no interest expense. EBIAT eliminates the impact of interest and taxes from the net income. EBIAT re-applies the tax rate to a pretax amount that excludes the cost of interest. The term "free cash flow" means that no outside entity has any claim on these funds.

EBIAT re-applies the tax rate to a pretax amount that excludes the cost of interest. This is the correct answer! This statement is true.

Which method does the lessee have more control? Operating lease Finance lease

Finance lease

Which method is economically similar to purchasing the asset? Operating lease Finance lease

Finance lease

The founders of a business are interested in investing in a project in the coming year, and they have two different projects to choose from. The estimated cash flows of the two projects are indicated as follows. The company's Weighted Average Cost of Capital (WACC) is 9%. Calculate the IRR of each project.

For Project 1, the correct answer is 10.62% The correct answer formula, which should be entered into cell E4, is the following: =IRR(B3:B10) For Project 2, the correct answer is 9.43% The correct answer formula, which should be entered into cell E16, is the following: =IRR(B15:B22)

Free Cash Flow

Free cash flow is the amount of cash that a business could be expected to generate from its normal operations. An amount meant to represent the cash flows that a company could be expected to generate from its normal operations for a given period without considering the impact of how the business is financed. In this course we use the following formula to calculate free cash flows: FCF = (1-t) x EBIT + Dep - Capx - D NWC where t is the tax rate, Dep is depreciation expense, Capx is capital expenditures and D NWC is the change in net working capital.

Gordon Growth Model

Gordon Growth Model: P = CF / (r - g) A method for calculating the terminal value of an indefinite stream of cash flows. The calculation gives the present value of infinite cash flows by dividing the cash flow in the final year of our projection by the difference between the discount rate and the growth rate. This model makes a major assumption that growth will remain steady indefinitely. As a result, this model should only be used once the cash flows are expected to stabilize. In periods of high growth or expected fluctuations, businesses should project the cash flows on a yearly basis.

Gordon Growth Model equation

Gordon Growth Model: P = CF / (r - g) P - Present value of the future cash flows CF - Cash flow expected in the last year projected r - Discount rate g - Expected growth rate

Please fill in ROU Asset, Lease Liability, Amortization Expense, and Interest Expense in the spreadsheet below based on preceding journal entries. Assuming there is no tax and gross profit at a constant $650,000/year. HINT: Take a close look at the embedded Year 1 formulas. Try to answer with spreadsheet formulas to avoid rounding errors.

Initial lease liability = Initial ROU asset = PV of Contracted Lease Payments = $777 Annual straight-line amortization expense = $777/5 = $155 ROU asset of "year n" = ROU asset of "year n − 1" − Amortization expense of "year n" Interest expense of "year n" = Lease liability of "year n − 1" × 0.7% Lease liability of "year n" = Lease liability of "year n − 1" − (Lease payment of "year n" − Interest expense of "year n")

When projecting financial statements, which of the following accounts is difficult to forecast using the percent of sales method? Accounts Receivable Accounts Payable Interest Expense Cost of Sales

Interest Expense Normally, Accounts Receivable, Accounts Payable, and Cost of Sales will trend in a direct relationship with sales. However, Interest Expense is more dependent upon the level of borrowings which does not necessarily track with sales.

What is free cash flow? It is "free" money, which means it is available at a 0% interest rate. It is the amount of cash that a business could be expected to generate from its normal operations. Free Cash Flow is another name for Net Income. It is the total amount of money being transferred into and out of a business.

It is the amount of cash that a business could be expected to generate from its normal operations. Free cash flow is the amount of cash that a business could be expected to generate from its normal operations.

An automotive parts company that sells to automotive manufacturers is forecasting revenue as part of its internal budgeting and planning process. Which of the following is LEAST likely to be important in its forecasting assumptions? Expected number of customers Customer acquisition and retention rates Profitability of customer orders Level of long-term debt

Level of long-term debt The level of long-term debt would not likely impact the revenue forecast.

On which financial statements would you be most likely to find information about capital expenditures related to the purchase of equipment during the past year? Look at the ending balance of the PPE account in the balance sheet Look for a large decrease in cash or large increase in accounts payable on the balance sheet Look for a change in the depreciation expense on the income statement Look at the investing section in the statement of cash flows

Look at the investing section in the statement of cash flows The correct answer is to look at the investing section in the statement of cash flows. The other alternatives would only give partial, and possibly misleading, information about capital expenditures. The investing section of the statement of cash flows would directly show the cash spent on capital purchases.

A CFO of a start-up company is evaluating the timing of a significant capital expenditure. He was previously at a mature company that used a discount rate of 8% so he used the same rate at the start-up company. Which of the following would be impacted if the discount rate were raised to reflect the risk of the start-up company? Internal rate of return Payback period Return on investment Net present value

Net present value NPV is the only one of the answer choices that is impacted by the discount rate.

Which of the following options is true in regards to financial forecasts? Forecasts are calculated based on historical data figures so they are extremely accurate. All cash flows will increase or decrease proportionately to forecasted sales numbers. Forecasts are exclusively used internally by management on a company level for general budgeting purposes. Odds are, forecasts will differ from actual results.

Odds are, forecasts will differ from actual results. Because of the assumptions that need to be made when creating forecasts and the subjectivity involved in making those assumptions, a financial forecast may be good base idea of the company's future operations, but they will most likely not be exactly correct.

A company is considering which of four mutually exclusive projects it should take. The projects are described as below: Project - NPV - IRR - Payback Period (years) Project 1 - $60,800 - 25.3% - 6.5 Project 2 − ($5,000) - 9.6% - 1.8 Project 3 - $29,100 - 18.7% - 2.4 Project 4 - $34,600 - 31.8% - 3.9 The company's maximum acceptable payback period is 6 years. The discount rate is 10 percent. Which project should it select? Project 1 Project 2 Project 3 Project 4

Project 1 This project is excluded because its payback period exceeds (6.5 yrs) the company's maximum acceptable payback period (6 yrs). Project 2 This project is excluded because it has a negative NPV (-$5,000). Project 3 Project 3 has an acceptable payback period, but its NPV and IRR are not as high as Project 4's. Project 4 This is the correct answer! As Project 1 and Project 2 are excluded, we just need to compare the two projects left. Project 4 has a higher NPV and a higher IRR than Project 3. Consequently, among the four mutually exclusive projects, Project 4 is the optimal choice.

Project 1: IRR: 13.34% NPV: $26,468 Project 2: IRR: 23.40% NPV: $41,434 Based on the calculations provided, which project should the company undertake? Project 1 Project 2

Project 2 has both a higher NPV and IRR, making it the preferable choice.

Relevant Cash Flows

Relevant cash flows are those future cash flows that would occur only if the potential project or investment being evaluated were to be implemented. In other words, they are the incremental cash flows related to the potential project or investment.

Applied Medical Services buys a diagnostic piece of equipment for $326,000. The machine will be depreciated on a straight-line basis for 10 years with a salvage value of $75,000. The company expects the machine to be able to generate after-tax cash flows of $64,000 in each of the 10 years, and then it will sell the machine for $75,000 at the end of 10 years. What are the cash flows related to this purchase for each of the next 10 years? Ignore taxes.

The annual cash flows will commence at the beginning of year 1 when the piece of equipment is purchased. This will be a negative cash flow of $326,000. In the next 9 years, the company will benefit from the $64,000 of after-tax cash flow generated each year. In year 10 the company will also benefit from the salvage value of $75,000 bringing that year's cash flow to $139,000. t - Cash Flow 0 - 326,000 1 - 64,000 2 - 64,000 3 - 64,000 4 - 64,000 5 - 64,000 6 - 64,000 7 - 64,000 8 - 64,000 9 - 64,000 10 - 139,000

Suppose you are considering buying a machine that costs $7,000. It will generate revenues of $1,500 for the next 3 years, and then $1,000 for the following 5 years. What is the payback period of this investment?

The best way to calculate the payback period is to calculate the cumulative cash flows. Another way to think of the payback period is that it is the break-even point, or the point in time at which positive cash flows and negative cash flows incurred to date net to zero. By calculating the cumulative cash flows, it is easy to see when the cash flows flip from being negative to being positive. If it doesn't flip exactly at the end of a certain year, then you just need to find the portion of the following year that it takes to recover the remaining cash outlay. To solve this problem, enter the following formula into cell F3: =A7−(C7/B8) Note that this formula takes the number of years just before cumulative cash flows flip from being negative to being positive, and then adds the fraction of the year it takes for the remaining cash outlay to be recovered in the following year.

A company is considering buying a diagnostic piece of equipment for $250,000. The machine will be depreciated on a straight-line basis for 10 years with a salvage value of $40,000. The company expects the machine to be able to generate after-tax revenues of $33,000 in each of the 10 years, and then it will sell the machine for $40,000 at the end of 10 years. The sum of the undiscounted cash flows is $370,000. The discount rate is 7%. The net present value is calculated to be $2,112. Which of the following statements is true? The company should not buy the equipment because the NPV is less than the annual revenues expected. The company should not buy the equipment because the NPV is less than the initial cost of the equipment. The company should buy the equipment because the sum of the undiscounted cash flows is greater than the initial cost of the equipment. The company should buy the equipment because the NPV is positive.

The company should buy the equipment because the NPV is positive. As long as the NPV is positive, even if it is a very small positive number, it means the company will earn a return greater than its discount rate, so it is a good investment.

A company is considering which of the two mutually exclusive projects it should undertake. The estimated cash flows and NPV of the two projects are shown in the following spreadsheet. The company's Weighted Average Cost of Capital (WACC) is 7 percent. Calculate the IRR of each project.

The correct answer for Project 1 is 13.34 percent. The correct answer formula is: =IRR(B3:B10) The correct answer for Project 2 is 23.40 percent. The correct answer formula is: =IRR(B15:B22)

A company is considering investing in a new project with infinite life. The estimated cash flows of the first three years of the project are shown as below: 2021: $12,000 2022: $15,000 2023: $21,000 After 2023, the annual cash flow of the project is expected to stabilize at about 1 percent growth. The discount rate is 6 percent. What is the present value of the project on January 1, 2021? Present value of $1 for 1 year at 6 percent is 0.94340 Present value of $1 for 2 years at 6 percent is 0.89000 Present value of $1 for 3 years at 6 percent is 0.83962 $373,799 $398,470 $416,102 $487,503

The correct answer is $398,470. Because cash flow is expected to grow at a stable rate of 1 percent after 2023, the cash of 2024, the first period of stabilized period, is $21,000 × 1.01 = $21,210. According to the Gordon Growth Model, Terminal Value = CF / (r − g) = $21,210 / (6% − 1%) = $424,200 Present Value on January 1, 2021 = ($12,000 × 0.94340) + ($15,000 × 0.89000) + ($21,000 × 0.83962) + ($424,200 × 0.83962) = $398,470

Clean Air Systems buys a diagnostic piece of equipment for $270,000. The machine will be depreciated on a straight-line basis for 10 years with a salvage value of $50,000. The company expects the machine to be able to generate after-tax cash flows of $43,000 in each of the 10 years, and then it will sell the machine for $50,000 at the end of 10 years. The discount rate is 7%. What is the Net Present Value?

The correct answer is $57,431. The correct answer formula, which should be entered into cell E5, is the following: =NPV(E4,B3:B12)+B2 Remember, for NPV you have to manually add the negative outflow from time zero related to the initial investment. where E4 is the rate B3:B12 is the cash flows minus initial B2 is initial

A project has the estimated cash flows shown in the following spreadsheet. The discount rate is 5 percent. Calculate the NPV of this project.

The correct answer is $70,171. The correct answer formula is: =NPV(E4,B3:B9)+B2 where E4 = rate B3:B9 = all cash flow data not including initial B2 = initial

A project has the estimated cash flows indicated in the following spreadsheet. The discount rate is 7%. Calculate the NPV of this project.

The correct answer is -$7,124 The correct answer formula, which should be entered into cell E5, is the following: NPV(E4,B3:B7)+B2 Remember, for NPV you have to manually add the negative outflow from time zero related to the initial investment. where E4 is the rate B3:B7 is the cash flows minus initial B2 is initial

A project has the estimated cash flows indicated in the following spreadsheet. The discount rate is 8% and the NPV is $17,924. Calculate the IRR of this project.

The correct answer is 18.97%. The correct answer formula, which should be entered into cell E6, is the following: =IRR(B2:B7)

A project has the estimated cash flows shown in the following spreadsheet. The discount rate is 5 percent and the NPV is $70,171. Calculate the IRR of this project.

The correct answer is 29.84 percent. The correct answer formula is: =IRR(B2:B9) B2:B9 = all cash flows

A project has an initial cost of $44,000. Expected cash flows as a result of this project are projected as follows. Calculate the payback period for this project. Assume a discount rate of 9%.

The correct answer is 3.5 years. At the end of year 3 the project has returned $35,000 ($10,000 + $10,000 + $15,000). This leaves $9,000 to be returned to hit payback. Assuming that the $18,000 projected for year 4 comes in a steady stream, this would mean it would take half of that year.

A company is considering which of four mutually exclusive projects it should take. The projects are described as below: Project - NPV - IRR Project 1 − $12,600 - 8.2% Project 2 - $41,500 - 13.5% Project 3 - $28,960 - 11.7% Project 4 - $34,900 - 12.4% Each project involves an initial investment of $500,000 and has a 10-year life. The company's Weighted Average Cost of Capital (WACC) is 9 percent. Which project should it select? Project 1 Project 2 Project 3 Project 4

The correct answer is Project 2. Among the four mutually exclusive projects, Project 2 has the highest NPV and the highest IRR, so it should be selected.

The founders of a business are interested in investing in a project in the coming year. The two projects are mutually exclusive. The estimated cash flows of the two projects are indicated as follows. The company's Weighted Average Cost of Capital (WACC) is 9%. The following table shows the data from the previous spreadsheet exercise and the correct IRR calculation. Project 1: IRR: 8.55% Project 2: IRR: 9.60% Which project should the company undertake? Project 1 Project 2

The correct answer is Project 2. Project 2 has the higher IRR and the IRR for Project 1 is below the WACC of 9%.

Company A estimates that it needs 30% of sales in net working capital. In year 1, sales were $1 million and in year 2, sales were $2 million. Associated with the change in net working capital from year 1 to year 2 is a cash: inflow of $300,000. outflow of $300,000. inflow of $600,000. outflow of $600,000.

The correct answer is an outflow of $300,000. The company would need to make a cash investment (outflow) of $300,000 to increase their net working capital from the $300,000 needed to support $1 million of sales to the $600,000 needed to support $2 million of sales.

A company is considering investing in a new project with infinite life. The estimated cash flows of the first five years of the project are shown as below: 2021: $650 2022: $1,240 2023: $2,250 2024: $3,670 2025: $4,200 After 2025, the annual cash flow of the project is expected to stabilize at about 3 percent growth. The discount rate is 7 percent. What is the terminal value of the project on January 1, 2026? $60,000 $64,200 $105,000 $108,150

The correct answer is: $108,150 Because cash flow is expected to grow at a stable rate of 3 percent after 2025, the cash of 2026, the first year of the stabilized period, is $4,200 × 1.03 = $4,326. According to the Gordon Growth Model, Terminal Value = CF / (r − g) = $4,326 / (7% − 3%) = $108,150

Cybertrex, a manufacturing facility, rented a new piece of equipment on January 1st and agreed to pay an annual rental fee of $18,000 at the end of each of the next 10 years. The weighted average cost of capital of the company is 8%. The present value of $1 for 10 years at 8% is 0.46319 The present value of an ordinary annuity of $1 for 10 years at 8% is 6.71008 What is the Present Value of the rental payments over 10 years? $180,000 $55,945 $8,337 $120,781

The correct answer is: $120,781 It is calculated by multiplying the annual payment by the present value of an annuity factor. $18,000 * 6.71008 = $120,781

A project's estimated net cash flows are shown as follows. The discount rate is 6 percent. 1: ($40,000) 2: $12,000 3: $12,000 4: $12,000 5: $12,000 6: $12,000 7: $12,000 8: $18,000 What is the Net Present Value of the project? Present value of $1 for 7 years at 6 percent is 0.66506 Present value of an annuity of $1 for 6 years at 6 percent is 4.91732 Present value of an annuity of $1 for 7 years at 6 percent is 5.58238 $22,998 $30,979 $38,960 $70,979

The correct answer is: $30,979 NPV = (−$40,000) + ($12,000 × 4.91732) + ($18,000 × 0.66506) = $30,979 Or NPV = (−$40,000) + ($12,000 × 5.58238) + ($6,000 × 0.66506) = $30,979

Company X is considering investing in a new project. The new project requires an initial investment of $180,000 and is expected to generate annual after-tax net cash inflows of $25,000 for 15 years. The discount rate is 8 percent. What is the NPV of the project? Present value of $1 for 15 years at 8 percent is 0.31524 Present value of an annuity of $1 for 15 years at 8 percent is 8.55948 $61,785 $33,987 $195,000 $213,987

The correct answer is: $33,987 NPV = (Initial investment) + present value of operating cash flows = (−$180,000) + ($25,000 × 8.55948) = $33,987

Company Y is considering purchasing a new machine. The new machine has a cost of $50,000, and is expected to generate annual after-tax net cash inflow of $10,000. The useful life of the machine is 8 years. NPV at 9 percent = $5,348 NPV at 10 percent = $3,349 NPV at 11 percent = $1,461 NPV at 12 percent = −$324 NPV at 13 percent = −$2,012 Which of the following numbers is closest to the internal rate of return? 9.5 percent 10.5 percent 11.5 percent 12.5 percent

The correct answer is: 11.5 percent IRR is the discount rate at which the NPV of an investment equals zero. Because NPV at 11 percent is positive while NPV at 12 percent is negative, IRR must fall between 11 percent and 12 percent.

A project has an initial cost of $155,000. The estimated net cash flows of the project are as follows: (The discount rate is 8 percent.) Year - Net Cash Flows - Discounted Net Cash Flows Year 1 - $30,000 - $27,778 Year 2 - $30,000 - $25,720 Year 3 - $28,000 - $22,227 Year 4 - $28,000 - $20,581 Year 5 - $28,000 - $19,056 Year 6 - $22,000 - $13,864 Year 7 - $22,000 - $12,837 Year 8 - $22,000 - $11,886 What is the project's payback period? 5.0 years 5.5 years 7.0 years 7.7 years

The correct answer is: 5.5 years The payback period is the period of time required to recover the cost of an investment. It ignores the time value of money. In this example, the sum of net cash flows of the first 5 years is $144,000. Payback Period = 5 + ($155,000 - $144,000) / $22,000 = 5.5 years.

Which of the following would NOT be considered a relevant cash flow in determining if a company should invest in a new project? The travel cost for staff assigned to work on the new project The cost already incurred to have a consulting firm do market research The cost of research and development still needed to get the project to be feasible The cost of marketing to sell the project once it reaches feasibility

The cost already incurred to have a consulting firm do market research This is the correct answer! This is NOT a relevant cash flow. Because the cost has already been incurred, it is considered a sunk cost. This cost is not incremental to the project and is not a relevant cash flow.

Which of the following would NOT be considered a relevant cash flow in determining if a company should invest in a new project? The revenues expected to be generated by the new project several years after the project begins The cost of hiring additional staff to run the new project The cost of office space already owned with capacity to house the new project The cost of software that needs to be acquired to run the new project

The cost of office space already owned with capacity to house the new project This is the correct answer! This is NOT a relevant cash flow. Because the office space is already owned, this cost is not incremental to the project and will be incurred regardless of the investment. Thus, it is not a relevant cash flow.

Which of the following statements is NOT true regarding the calculation of terminal value under the Gordon Growth Model? Terminal value is the present value of cash flows expected in the indefinite future. A major assumption of terminal value model is that the growth rate will remain fixed. The higher the discount rate, the greater the terminal value is. Assuming positive cash flows, the higher the growth rate, the greater the terminal value is.

The higher the discount rate, the greater the terminal value is. This is the correct answer! This statement is NOT true. Gordon Growth Model: P = CF / (r - g) P - Present value of the future cash flows CF - Cash flow expected in the last year projected r - Discount rate g - Expected growth rate According to the Gordon Growth Model, the higher the discount rate, the smaller the Terminal Value is.

Present Value

The value in today's currency of a future amount or a series of future amounts which have been converted into today's currency value using the discount rate. Can be found using Present Value tables, calculators, or software programs with Present Value functions. Also can be calculated using the following formula for any given amount in the future: PV = FV*(1/(1+i)n) where PV equals the present value, FV equals the future value that is being converted to its present value, i equals the discount rate, and n is the number of periods into the future that the future value exists. There are also tables and functions that can be used to find the present value of an annuity.

A company has retained earnings of $94,000 as of December 31, 2014. The Pro-forma income statement projects net income of $22,000 for 2015. The company expects to declare their annual dividend on March 15, 2015 of $0.70 per share and has a total of 100,000 shares outstanding. What will the projected retained earnings account be as of December 31, 2015? $186,000 $46,000 $16,000 $2,000

To calculate the projected retained earnings, you add the projected 2015 net income of $22,000 to the beginning balance of $94,000 carried over from 2014. Then you must subtract $70,000 for the dividend of $0.70 per share times the 100,000 shares outstanding. $94,000 + $22,000 - $70,000 = $46,000

Suppose you are considering buying a machine that costs $7,000. It will generate revenues of $1,500 for the next 3 years, and then $1,000 for the following 5 years. If your discount rate is 8 percent, what is the NPV of this investment?

To solve this problem, enter the following formula into cell E3: =NPV(E2,B3:B10)+B2 The correct answer is $35. Because the NPV is positive, even though it is very small, it means that the sum of the discounted cash inflows is greater than the sum of the discounted cash outflows, so the project would yield a return greater than the discount rate.

Suppose you are considering buying a machine that costs $7,000. It will generate revenues of $1,500 for the next 3 years, and then $1,000 for following 5 years. What is the internal rate of return on this investment?

To solve this problem, enter the following formula into cell E4: =IRR(B2:B10)

Example: A company is considering investing in a new project with infinite life. The estimated cash flows of the first three years of the project are shown as follows: 2021: $1000 2022: $1500 2023: $2000 After 2023, the annual cash flow of the project is expected to stabilize at about 2 percent growth. The discount rate is 5 percent. What is the Present Value of the project on January 1, 2021? The present value of $1 for 1 year at 5 percent is 0.95238 The present value of $1 for 2 years at 5 percent is 0.90703 The present value of $1 for 3 years at 5 percent is 0.86384

We have already calculated that the terminal value is $68,000. Now, we just need to find the present value of all cash flows, including the terminal value. ($1,000 × 0.95238) + ($1,500 × 0.90703) + ($2,000 × 0.86384) + ($68,000 × 0.86384) = $62,780 So the present value of the project on January 1, 2021 is $62,780.

Which of the following would NOT have an impact on the IRR of a project? Weighted average cost of capital Project life span Relevant cash flows Initial investment

Weighted average cost of capital This is the correct answer! IRR is the discount rate at which the net present value of an investment equals zero. Weighted average cost of capital does not impact IRR.

EBIT

earnings before interest and taxes

Internal rate of return (IRR)

indicates the estimated annual growth of an investment, and it's the discount rate value that would set the project's NPV to zero. That said, if: the actual discount rate of a project (cost of capital) is higher than its IRR: the actual NPV would turn out to be negative; if the actual discount rate of a project (cost of capital) is lower than its IRR, the actual NPV would be positive. Therefore, a project with an IRR greater than its cost of capital should be profitable.

Net Present Value (NPV)

the difference between the present value of cash inflows and the present value of cash outflows over a certain period of time. In the real world, NPV is often used to evaluate investment opportunities and decide capital allocation. Investors are constantly looking for positive NPV opportunities since it indicates that the anticipated earnings of such investment are greater than the estimated costs. That is, a project with a: - positive NPV will be profitable, - negative NPV will result in a net loss. In short, as a rational investor, you should only consider investments with positive NPVs.

The information for calculating EBIT comes from

the income statement

time value of money

the principle that a dollar received today is worth more than a dollar received in the future The concept that a unit of currency (such as a dollar) received today is worth more than the same unit of currency received at some future point. Furthermore, the further into the future, the less the unit of currency is worth. This is because of three factors; the opportunity cost of not having the currency to invest, the impact of inflation, and the risk of not receiving the unit of currency in the future.

Once the expected sales have been determined, the next step is

to look for trends and relationships among the various components of costs. For instance, one trend that often arises is a strong correlation between a given account and the level of sales.

Percent of Sales Forecasting

we make projections based on the assumption that certain costs and selected balance sheet items are best expressed as a percentage of sales.

A project with a positive NPV

will be profitable

A project with a negative NPV

will result in a net loss

Metropolis had net sales of ₹120 million in 2020 related to pathology services. They expect sales of pathology services to grow by 75 percent in 2021. Metropolis also plans to introduce a new service, Home Healthcare Blood Draws, which will generate sales of ₹10 million in 2021. What will be the forecasted net sales for 2021? ₹120 ₹10 ₹220 ₹75

₹220 Pathology revenue is expected to increase by 75 percent and Home Healthcare Blood Draws revenue is expected to add ₹10 million. In order to calculate, multiply the prior year's revenue by 175 percent and add ₹10 million. Calculation: (120.0 × 1.75) + 10 = 220.0

For Metropolis, sales and marketing expenses are expected to be 12 percent of revenue. With forecasted sales revenue of ₹220 for 2021, what will be the forecasted sales and marketing expenses for 2021? ₹10.2 ₹12.1 ₹22.2 ₹26.4

₹26.4 Sales and marketing expenses are expected to be 12 percent of net sales. In order to calculate, multiply 2021 sales by 12 percent. Calculation: (220.0 × 0.12) = 26.4

Metropolis had net sales of ₹120 million in 2020 related to pathology services. This revenue grew by 75 percent in 2021. Metropolis expects sales of pathology services to grow by 75 percent again in 2022. Home Healthcare Blood Draws will generate sales of ₹20 million in 2022. What will be the forecasted net sales for 2022? HINT: You must compound the 2020 sales (₹120 million) twice rather than simply multiplying the 2021 revenue by 175 percent because the 2021 revenue includes ₹10 million of Home Healthcare Blood Draws revenue. ₹20 ₹220 ₹75 ₹387.5

₹387.5 Pathology revenue is expected to increase by 75 percent and Home Healthcare Blood Draws revenue is expected to add ₹20 million. In order to calculate, multiply the 2020 revenue by 175 percent compounded twice and add ₹20 million. Calculation: (120.0 × 1.75 × 1.75) + 20 = 387.5

Metropolis had net sales of ₹120 million in 2020 related to pathology services. This revenue grew by 75 percent per year in the following two years. Metropolis expects sales of pathology services to grow by 50 percent in 2023. Home Healthcare Blood Draws will generate sales of ₹30 million in 2023. Metropolis also plans to introduce a new service, Preventive Healthcare Screening, which will generate sales of ₹30 million in 2023. What will be the forecasted net sales for 2023? HINT: You must compound the 2020 revenue three times (twice by 75 percent and once by 50 percent) rather than simply multiplying the 2022 revenue by 150 percent. ₹387.5 ₹611.3 ₹50 ₹30

₹611.3 Pathology revenue is expected to increase by 50 percent, Home Healthcare Blood Draws revenue is expected to add ₹30 million, and Preventive Healthcare Screening is expected to be ₹30 million. In order to calculate, multiply the 2020 revenue by 175 percent compounded twice and by 150 percent compounded once, and add ₹30 million plus another ₹30 million. Calculation: (120.0 × 1.75 × 1.75 × 1.50) + 30 + 30 = 611.3

The primary costs that make up the cost of sales for Metropolis are employee costs, chemical costs, and supplies costs. Employee costs are forecast to be 20 percent of revenue, chemical costs are forecast to be 20 percent of revenue, and supplies costs are forecast to be 5 percent of revenue, for a total of 45 percent. With forecasted sales revenue of ₹220 for 2021, what will be the forecasted cost of sales for 2021? ₹220 ₹45 ₹99 ₹20

₹99 Cost of sales is forecast to be 45 percent of net sales (sum of employee cost, 20% + chemical cost, 20% + supplies cost, 5%). In order to calculate, multiply 2021 sales by 45 percent. Calculation: (220.0 × 0.45) = 99.0