FIN 300 Chapter Notes - Chapter 10: Tax Shield, Operating Cash Flow, Cash Flow

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28 Jun 2018

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FIN – Chapter 10 – Making Capital Investment Decisions

A relevant cash flow for a project is a change in the firm’s overall future cash flow that comes

about as a direct consequence of the decision to take that project

The relevant cash flows are called the incremental cash flows associated with the project

Incremental cash flows – the difference between a firm’s future cash flows with a

project and those without the project

The incremental cash flows for project evaluation consist of any and all changes in the firm’s

future cash flows that are a direct consequence of taking the project

Sunk cost – a cost that has already been incurred and cannot be removed and therefore should

not be considered an investment decision (firm will have to pay cost no matter what)

Opportunity cost – the most valuable alternative that is given up if a particular investment is

undertaken

Erosion – the cash flows of a new project that come at the expense of a firm’s existing projects

Erosion is relevant only when the sales would not otherwise be lost

Interest paid or any other financing costs (dividends or principal repaid) will not be included

because we are interested in the cash flow generated by the assets or the project

Interested in measuring cash flow when in occurs, not when it accrues. Interested in after tax

cash flows

Pro forma financial statements – financial statements projecting future years operations

Interest paid is a financing expense, not a component of operating cash flow

Project cash flow = project operating cash flow – project change in NWC – project capital

spending

Operating cash flow = EBIT + Depreciation – Taxes

Total cash flow = operating cash flow – change in NWC – capital spending

Cash in come = sales – increase in A/R

Including NW changes in calculations has the effect of adjusting for the discrepancy between

accounting sales and costs and actually cash receipts and payments

Modified ACRS depreciation (MARCS) – every assets is assigned to a particular class which

establishes its life tax tax purposes. The depreciation for each year is computed by multiplying

the cost of the asset by a fixed percentage

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Document Summary

Fin chapter 10 making capital investment decisions. A relevant cash flow for a project is a change in the firm"s overall future cash flow that comes about as a direct consequence of the decision to take that project. The relevant cash flows are called the incremental cash flows associated with the project. Incremental cash flows the difference between a firm"s future cash flows with a project and those without the project. The incremental cash flows for project evaluation consist of any and all changes in the firm"s future cash flows that are a direct consequence of taking the project. Sunk cost a cost that has already been incurred and cannot be removed and therefore should not be considered an investment decision (firm will have to pay cost no matter what) Opportunity cost the most valuable alternative that is given up if a particular investment is undertaken.

Related Questions

Which of the following should be included in the capital budgeting decision

Select one:

A. Sunk costs

B. Opportunity costs

C. Relevant externalities

D. #2 and #3 should be included

E. All of the above should be included

Which of the following is NOT correct

Select one:

A. If an investment project would make use of land which the firm already owns, the opportunity cost of the land is a relevant cash flow and should be included with other project cash flows

B. Analysis of capital projects focuses on cash flows rather than accounting income

C. Changes in working capital do not need to be considered in capital project analysis

D. All of the above are correct

Stock dividends

Select one:

B. must be accompanied by cash dividends

C. are viewed unfavorably by investors and thus should not be used

D. have the same effect on financial statements as cash dividends

A project has initial costs of $5,000 and subsequent cash inflows of $1800, 1275, 1875, and 1525. The company's cost of capital is 10%. Calculate the Payback Period for the project

Problem 1

All Techniques- Decision among mutually exclusive investments. Pound industries is attempting to select the best of three mutually exclusive projects. The initial investment and after tax cash inflows associated with these projects are shown in the following table

Cash flow Project A Project B Project C

Initial investment (CF) $80,000 $110,000 $110,000

Cash inflows (CF), T=1 to 5 $25,000 $37,000 $38,500

Calculate the payback period for each project

Calculate the net present value (NPV) of each project, assuming that the fimrm has a cost of capital equal to 11%

Calculate the internal rate of return (IRR) for each project

Indicate which project you would recommend

A-the payback period of project A is ___years

the payback period of project B is ___years

the payback period of project C is ___years

B-the NPV of project A is $____

the NPV of project B is $____

the NPV of project C is $____

C- The IRR of project A is _____

The IRR of project B is _____

The IRR of project C is _____

D- which project would you recommend?

Project A

Project B

Project C

Problem 2

IRR, investment life, and cash inflows Oak enterprise accepts projects earning more than the firms 15% cost of capital. Oak is currently considering a 10 year project that provides annual cash inflows of $50,000 and requires an initial investment of $328,300

Deter the IRR of the project is it acceptable

Assuming that the cash inflos continue to be $50,000 per year how many additional years would the flows have to continue to make the project acceptable (that is, to make it have an IRR of 15%?

A. the project IRR is ___%

Is the project acceptable?

Yes or no

B. assuming that the cash inflows continue to be $50,000 per year the number of additional years the flows would have to continue to make the project acceptable at the 15% discount rate is ____ additional years

C) with the given life, initial investment and cost of capital the minimum annual cash inflow that the firm should accept is $______

greyswan843

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?

FIN 300 Chapter Notes - Chapter 10: Tax Shield, Operating Cash Flow, Cash Flow

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