FIN 3104 Study Guide - Final Guide: Sensitivity Analysis, Systematic Risk, Public Company

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purpleduck94

11 Dec 2016

School

Virginia Tech

Department

Finance, Insurance, Business Law

Course

FIN 3104

Professor

Keown

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Chapter 11 pg 368-382

 Firms can reinvest free cash flows, not accounting profits

 In deciding if a cash flow is incremental, look at the company with, versus

without, the new project

 Any incremental after-tax cash flow affecting the company as a whole is

a relevant cash flow, whether flowing in or flowing out

 Sunk costs are not incremental cash flows – it’s all about timing

o Any cash flows that are not affected by the accept/reject criterion

should not be included in capital budgeting

Calculating a Project’s Free Cash Flows

 Initial Outlay – immediate cash outflow necessary to purchase the asset

and put it in operating order

o Amount includes the cost of purchasing the asset and any

increases in in working-capital

o = Cost of new asset – Sales price of old +/- Taxes

 To go from operating cash flows to free cash flows the following needs to

be changed:

o Depreciation and taxes

 Annual depreciation = Initial depreciable value /

depreciable life

o Interest expenses

o Changes in networking capital

o Changes in capital spending

 EBIT = revenue – fixed & variable costs – depreciation

 Operating Cash Flows = EBIT – Taxes + Depreciation

 Free Cash Flows = EBIT – Taxes + Depreciation – Net working capital

MyFinanceLab Verbals on Cash Flows:

1) Cash flows that have already taken place are often referred to as sunk costs,

cash flows that are lost because a given project consumes scarce resources that

would have produced cash flows if that project had been rejected are often

referred to as opportunity costs, and cash flows that a firm receives and is able to

reinvest are often referred to as incremental cash flows

2) If Ford introduces a new auto line, might some of the cash flows from that new

car line be diverted from existing product lines?

If Ford introduces a new auto line that might compete with the firm's existing

product lines, then only the incremental sales the new line brings to the

company should be considered in determining the free cash flows in capital-

budgeting analysis.

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Document Summary

Firms can reinvest free cash flows, not accounting profits. In deciding if a cash flow is incremental, look at the company with, versus without, the new project. Any incremental after-tax cash flow affecting the company as a whole is a relevant cash flow, whether flowing in or flowing out. Sunk costs are not incremental cash flows it"s all about timing: any cash flows that are not affected by the accept/reject criterion should not be included in capital budgeting. To go from operating cash flows to free cash flows the following needs to be changed: depreciation and taxes. Annual depreciation = initial depreciable value / depreciable life. Interest expenses: changes in networking capital, changes in capital spending. Ebit = revenue fixed & variable costs depreciation. Operating cash flows = ebit taxes + depreciation. Free cash flows = ebit taxes + depreciation net working capital.

Related Questions

Gammy is considering building a facility to manufacture cupcakes to distribute nationally. Your assignment involves both the calculation of cash flows associated with the new investment under consideration and the evaluation of several mutually exclusive projects. Grammy wants you to meet with everyone involved and write a meeting report for the board of directors that includes your recommendation. In addition to the recommendation, you have been asked to respond to a number of questions aimed at understanding the capital-budgeting process. Grammy wants to be sure that she and the board of directors understand cash flow and capital budgeting.

We are considering constructing a building to manufacture cupcakes. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the project:

Cost of new plant and equipment	$7,900,000
Shipping and installation costs	$ 100,000
Unit Sales	Year Units Sold 1 70,000 2 120,000 3 140,000 4 80,000 5 60,000
Sales price per unit	$300/unit in years 1 through 4, $260/unit in year 5
Variable cost per unit	$180/unit
Annual fixed costs	$200,000 per year in years 1 â 5
Working-capital requirements	There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The depreciation method	Use the simplified straight-line method over 5 years. Assume the plant and equipment will have no salvage value after 5 years.

5. Answer the following questions:

a. Should you focus on cash flows or accounting profits in making the capital-budgeting decision? Should you be interested in incremental cash flows, incremental profits, total free cash flow, or total profits?

b. How does depreciation affect free cash flow?

c. How do sunk costs affect the determination of cash flows?

d. What is the projectâs initial outlay?

e. What are the differential cash flows over the projectâs life?

f. What is the terminal cash flow?

g. Draw a cash-flow diagram for this project.

h. What is its net present value?

i. What is its internal rate of return?

j. Should the project be accepted? Why or why not?

k. How does Genesis 47: 18 â 19 relate to this project and cash flow management?

Problem 12-9
New project analysis

You must evaluate a proposal to buy a new milling machine. The base price is $164,000, and shipping and installation costs would add another $7,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $82,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $7,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $41,000 per year. The marginal tax rate is 35%, and the WACC is 11%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

How should the $5,000 spent last year be handled?

The cost of research is an incremental cash flow and should be included in the analysis.

Only the tax effect of the research expenses should be included in the analysis.

Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.

Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

-Select-IIIIIIIVVItem 1

What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent.
$

What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.
Year 1 $
Year 2 $
Year 3 $

Should the machine be purchased?
-Select-yesno

You must evaluate a proposal to buy a new milling machine. The base price is $167,000, and shipping and installation costs would add another $9,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $108,550. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $6,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $38,000 per year. The marginal tax rate is 35%, and the WACC is 10%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

How should the $5,000 spent last year be handled?

I. The cost of research is an incremental cash flow and should be included in the analysis.

II. Only the tax effect of the research expenses should be included in the analysis.

III. Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.

IV. Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

V. Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

I, II, III, IV or V?

What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent.
$

What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.
Year 1 $
Year 2 $
Year 3 $

Should the machine be purchased?

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FIN 3104 Study Guide - Final Guide: Sensitivity Analysis, Systematic Risk, Public Company

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