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FRL 367 Midterm I
Terms in this set (129)
Process of determing which projects (real assets) to invest in
Rule that states managers should consider only the NPV and accept ALL projects with positive NPV in making capital budgeting decisions
Incremental cash flows
The difference between a firm's future cash flows with a project and those without the projects- "will this cash flow occur ONLY if we accept the project?"
Cash flows _________ (matter / don't matter)
Sunk costs ______ (matter / don't matter)
Incremental cash flows ______ (matter / don't matter)
Opportunity costs _______ (matter / don't matter)
Side effects _______ (matter / don't matter)
Taxes _______ (matter / don't matter) -> We want incremental after-tax cash flows
A cost that has already occurred. Because these are in the past, they cannot be changed by the decision to accept or reject the project.
Potential lost revenues/opportunities because firm takes on a project
Occurs when taking on a new project. May be positive (synergy) or negative (erosion)
Occurs when a new project increases the cash flows of existing projects
Occurs when a new product reduces the sales, and hence, the cash flows of existing products
Net working capital (NWC)
Difference between current assets and current liabilities
A non-cash expense, only relevant because it affects taxes. Has two types: straight line & MACRS Schedule
Occurs when the salvage value is different from the book value of the asset
Net capital spending
Initial cash outflow at purchase of fixed assets (machines and equipments, factory, etc.) & sales of fixed assets at the end of the project life. => "Buying/selling machines"
Increases in NWC
Decreases in NWC
Changes in net working capital
Working capital rises over the early years of the project as expansion occurs, and drops at the later years of the project
OCF = Net Income + Depreciation where (NI= EBIT-Taxes); works only when there is no interest expense
OCF = Sales - Costs - Taxes ; Don't subtract non-cash deductions
Tax Shield approach
OCF = (Sales - Costs)(1-Tc) + Dep (Tc)
Revenues - Operating Costs - Depreciation
EBIT (taxable income)
Taxable income (EBIT) - Income tax
Depreciation tax shield
Depreciation deduction * Tax rate
After-tax Salvage Value occurs on year _____.
Total changes of NWC will equal to __.
Use _______ interest rates to discount nominal cash flows.
Use _____ interest rates to discount real cash flows
Real cash flows
The purchasing power of the actual cash flows
Nominal cash flow
The actual dollars to be received (or paid out)
Examines how sensitive a particular NPV calculation is to changes in underlying assumptions against ONE variable change (also known as what-if analysis and bop analysis) (best, optimistic, and pessimistic)
Costs that change as the output changes, and they are zero when production is zero; common to assume that a ____ cost is constant per unit of output, implying that total ____ costs are proportional to the level of production
Example of variable costs
Costs of direct labor and raw materials
Costs that are not dependent on the amount of goods or services produced during the period; usually is measured as costs per unit of time
Examples of fixed costs
Rent per month or salaries per year (management salaries)
True; fixed only over a predetermined time period
Fixed costs are not fixed forever. (True or False)
Steps of sensitivity analysis
1. Pick a variable
2. Vary it over range
3. NPV (or IRR) for each value
True or False: Sensitivity analysis treats each variable in isolation. Changes in one variable will not influence other variables.
Drawbacks of sensitivity analysis
-sensitivity analysis may unwittingly increase the false sense of security among managers
-a deviation of fixed percentage ignores the fact that some variables are easier to forecast than others
-sensitivity analysis treats each variable in isolation when, in reality, the different variables are likely to be related
A variant of sensitivity analysis, which examines a number of different likely scenarios, where each scenario involves a confluence of factors.
NPV or OCF or NI / underlying variable
Approach that determines the sales needed to break even; is a useful complement to sensitivity analysis because it also sheds light on the severity of incorrect forecasts.
Break-even measure, sales volume at which net income = 0
Break-even measure, sales volume at which operating cash flow = 0
Break-even measure, sales volume at which net present value = 0
Change in NPV
NPV new - NPV old
Difference between sales price and variable cost per unit
Monte Carlo simulation
An exercise that generates possible outcomes for a project based on a model of the underlying factors that drive project performance
After-tax salvage value
Capital spending that occurs at the last year
When performing a capital budgeting calculation, always discount _______. (Cash flows / earnings)
The difference between the asset's sale price and its book value
Residential and nonresidential
Real property is separated into two classes: ______ & ______. The cost of _____ property is recovered over 27 1/2 years and ________ property over 39 years.
Equivalent annual cost
Approach that adjusts for the difference in useful life when comparing two machines
A, B, D, F, G
Which of the following should be treated as an incremental cash flow when computing the NPV of an investment?
A. A reduction in the sales of a company's other products caused by the investment
B. An expenditure on plant and equipment that has not yet been made and will be made only if the project is accepted
C. Costs of research and development undertaken in connection with the he product during the past three years
D. Annual depreciation expense from the investment
E. Dividend payments by the firm
F. The resale value of plant and equipment at the end of the project's life
G. Salary and medical costs for production personnel who will be employed only if the project is accepted
Your company currently produces and sells steel shaft golf clubs. The board of directors wants you to consider the introduction of a new line of titanium bubble woods with graphite shafts. Which of the following costs are not relevant?
A. Land you already own that will be used for the project, but otherwise will be sold for $700,000, its market value
B. A $300,000 drop in your sales of steel shaft clubs if the titanium woods with graphite shafts are introduced
C. $200,000 spent on research and development last year on graphite shafts
MACRS (for tax purposes, a firm would choose this bc it provides for larger depreciation deductions earlier. These earlier deductions reduce taxes, but have no other cash consequences. Notice that the choice between MACRS & straight line is purely a time value issue, total depreciation is the same only timing differs)
Given the choice, would a firm prefer to use MACRS depreciation or straight-line depreciation?
Analysis of the effect on the project when there is some change in a critical variable, such as sales or costs
Analysis of the effect on a project of different scenarios with each scenario involving many variable changes
The option to perform an action in managing a business or as part of a project
A graphical representation of alternative sequential decisions and the possible outcomes of those decisions. This graphical representation helps to identify the best course of action. When making decisions, we always start from far right, and work BACKWARDS.
Monte Carlo simulation
Simulation of capital budgeting projects often viewed as a step beyond either sensitivity or scenario analysis; it is a further attempt to model real-world uncertainty
Steps of Monte Carlo simulation
1. Specify the basic model
2. Specify a distribution for each variable in the model
3. The computer draws one outcome
4. Repeat the procedure
5. Calculate the NPV
Options have value
One of the fundamental insights of modern finance theory is -
Examples of real options
The option to expand, the option to abandon, the option to delay
The option to expand
This type of real option has value if demand turns out to be higher than expected
The option to abandon
This type of real option has value if demand turns out to be lower than expected
The option to delay
This type of real option has value if the underlying variables are changing with a favorable trend
The risk that a poor decision is made because of errors in projected cash flows. The danger is greatest with a new product bc the cash flows are probably harder to predict.
Difference between sensitivity analysis and scenario analysis
With a sensitivity analysis, one variable is examined over a broad range of values. With a scenario analysis, all variables are examined for a limited range of values.
Financial break-even point (a project can exceed the accounting and cash break-even points but still be below the financial break-even point; this causes a reduction in your shareholder wealth)
As a shareholder of a firm that is contemplating a new project, would you be more concerned with the accounting break-even point, cash break-even point, or financial break even point?
Cash-break even, accounting break-even, financial break-even (for a project with an initial investment and sales afterwards, this order will always apply. Cash break-even is achieved first bc it excludes depreciation, accounting break-even is next bc it includes depreciation, financial break-even is last bc it includes the time value of money)
Assume a firm is considering a new typical project that requires an initial investment with sales, variable costs, and fixed costs over its life. Will the project usually reach the accounting, cash, or financial break-even point first? Which will it reach next? Last? Will this order always apply?
Traditional NPV analysis is often too conservative (bc it ignores profitable options such as the ability to expand the project if it is profitable, or abandon the project if it is unprofitable. The option to alter a project when it has already been accepted has a value, which increases the NPV of the project)
Why does traditional NPV analysis tend to underestimate the true value of a capital budgeting project?
Option to expand
The Mango Republic has just liberalized its markets and is now permitting foreign investors. Tesla manufacturing has analyzed starting a project in the country and has determined that the project has a negative NPV. Why might the company go ahead with the project? What type of option is most likely to add value to this project?
How does sensitivity analysis interact with break-even analysis?
Sensitivity analysis can determine how the financial break-even point changes when some factors change (fixed costs, variable costs, revenue)
Type of lease where the period of contract is less than the life of the equipment and the lessor pays all maintenance and servicing costs
A long-term, noncancelable lease that generally requires the lessee to pay all maintenance fees
Sale and lease-back
A type of financial lease where a firm sells its existing assets to a financial company which then leases them back to the firm. This is often done to generate cash.
A type of financial lease that is a tax-oriented leasing arrangement involving one or more third-party lenders
Contractual agreement between a lessee and lessor. Agreement establishes that the lessee has the right to use an asset and in return must make periodic payments to the lessor, the owner of the asset
Owner of the asset; either the asset's manufacturer or independent leasing company. If the _____ is an independent leasing company, it must first buy the asset from a manufacturer before delivering to the lessee.
Lease where it is usually not fully amortized, usually requires the lessor to maintain and insure the asset, and lessee enjoys a cancellation option
Financial lease (opposite of operating)
Lease where it does not provide for maintenance or service by the lessor, leases are fully amortizing, the lessee usually has a right to renew the lease at expiration, and cannot be cancelled.
Two things that occur in a sale and lease-back
1. The lessee receives cash from the sale of the asset
2. The lessee makes periodic lease payments, thereby retaining use of the asset
A three-sided arrangement between the lessee, lessor, and lenders:
- the lessor owns the asset and for a fee allows the lessee to use the asset
-the lessor borrows to partially finance the asset
-the lenders typically use a nonrecourse loan, meaning that the lessor is not obligated to the lender in case of a default by the lessee
How the lender is protected in a leveraged lease
1. The lender has a first lien on the asset
2. In the event of loan default, the lease payments are made directly to the lender.
Difference between operating lease and capital lease
Operating leases do not appear on the balance sheet, while capital leases do. (The present value of the lease payments of capital lease appears on both sides of balance sheet)
Accountants generally argue that a firm's financial strength is ____ related to the amount of its liabilities.
BC the lease liability is hidden with an operating lease, the balance sheet of a firm with an operating lease LOOKS ______ (stronger/weaker) than the balance sheet of a firm with an otherwise identical capital lease. Given the choice, firms would probably classify all their leases as operating ones.
Conditions for capitalized leases
A lease must be capitalized if any one of the following is met:
1. The PV of the lease payments is at least 90% of the fair market value of the asset at the start of the lease.
2. The lease transfers ownership of the property to the lessee by the end of the term of the lease
3. The lease term is 75% or more of the estimated economic life of the asset
4. The lessee can buy the asset at a bargain price at expiration.
Principal benefit of long-term leasing
True or false:
Leasing allows the transfer of tax benefits from those who need equipment but cannot take full advantage of the tax benefits of ownership to a party who can.
The reason the IRS is concerned about lease contracts is that many times they appear to be set up solely to ______.
Qualifications by the IRS for tax deductions
The lessee can deduct lease payments if the lease is-
1. The term must be less than 30 years
2. There can be no bargain purchase option
3. The lease should not have a schedule of payments that is very high at the start of thee lease and low thereafter
4. The lease payments must provide the lessor with a fair market rate of return
5. The lease should not limit the lessee's right to issue debt or pay dividends
6. Renewal options must be reasonable and reflect fair market value of the asset
Aftertax riskless rate of interest
In a world with corporate taxes, firms should discount riskless cash flows at the ________.
Aftertax riskless interest rate
In a world with corporate taxes, one determines the increase in the firm's optimal debt level by discounting a future guaranteed aftertax inflow at the ________.
Is like the debt service on a secured bond issued by the lesse
Depreciation tax shield and lease payments
In the real world, many companies discount both the _____ & _____ at the aftertax interest rate on secured debt issued by the lessee
Good reasons for leasing
-taxes may be reduced by leasing
-the lease contract may reduce certain types of uncertainty
-transaction costs can be higher for buying an asset and financing it with debt or equity than for leasing the asset
Bad reasons for leasing
-leasing and accounting income
-100% financing, which suggests that leases do not permit a greater level of total liabilities than do purchases with borrowing
Value of the property when the lease expires
Under a lease contract, the residual risk is borne by the _____ (lessor/lesse)
I, II, IV
All of the following are anticipated effects of a proposed project. Which of these should be included in the initial project cash flow related to net working capital?
I. An inventory decrease of $5,000
II. An increase in accounts receivable of $1,500
III. An increase in fixed assets of $7,600
IV. A decrease in accounts payable of $2,100
more complex than sensitivity or scenario analysis
Monte Carlo simulation is:
-none of these
-more complex than sensitivity or scenario analysis
-the method of analysis most widely used by executives
-a very simple formula
-the oldest capital budgeting technique
Eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project
One purpose of identifying all of the incremental cash flows related to a proposed project is to:
-make each project appear as profitable as possible for the firm
-identify any and all changes in the cash flows of the firm for the past year so they can be included in the analysis
-eliminate any cost which has been previously been incurred so that it can be omitted from the analysis of the project
-include both the proposed and the current operations of a firm in the analysis of the project
-isolate the total sunk costs so they can be evaluated to determine if the project will add value to the firm
I & III
Which of the following are correct methods for computing the operating cash flow of a project assuming that the interest expense is equal to zero?
I. EBIT + DEP - TAXES
II. EBIT + DEP + TAXES
III. NET INCOME + DEP
IV. (SALES - COSTS)
(TAXES + DEP)
Youngers Inc. paid $95,000, in cash, for a piece of equipment three years ago. Last year, the company spent $15,000 to update the equipment with the latest technology. The company no longer uses this equipment in its current operations and has received an offer of $80,000 from a firm who would like to purchase it. Youngers is debating whether to sell the equipment or to expand its operations such that the equipment can be used. When evaluating the expansion option, what value, if any, should Youngers assign to this equipment as an initial cost of the project?
All of these
-are zero when production is zero
-change as the quantity of output changes
-are exemplified by direct labor and raw materials
-none of these
-all of these
I, II, III
1. Are variable over long periods of time
II. Must be paid even if production is halted
III. Are generally affected by the amount of fixed assets owned by a firm
IV. Per unit remain constant over a given range of production output
All cash flows and probabilities
In a decision tree, the NPV to make the yes/no decision is dependent on:
-all cash flows and probabilities
-on the path where the probabilities add up to one
-only the cash flows from successful path
-none of these
-only the cash flows and probabilities of the successful paht
The decision as to when a project should be started
The investment timing decision relates to:
-how long the cash flows last once a project is implemented
-how frequently the cash flows of a project occur
-how frequently the interest on the debt incurred to finance a project is compounded
-the decision to either finance a project over time or pay out the initial cost in cash
-the decision as to when a project should be started
Because several variables are changed together
Scenario analysis is different than sensitivity analysis:
-because scenario analysis deals with actual data vs. sensitivity analysis which deals with a forecast
-because it is a "by the seat of the pants" technique
-because several variables are changed together
-because it is short and simple
-because no economic forecasts are changed
Must be disclosed in the lessee's annual report
-appear as offsetting items on the lessee's balance sheet
-are fully expensed at the time the lease is established
-are not included in the lessee's financial reports
-are treated the same as a purchase
-must be disclosed in the lessee's annual report
Early balloon payments
A lease with which one of these characteristics would not be qualified by the IRS?
-term of 25 years
-early balloon payments
-lessee option to purchase asset at fair market value at lease expiration
-no lease provision limiting the lessee' right to issue additional debt
-lessee granted first option to meet a competing outside renewal offer
Changes in operating costs related to the acquired asset
Which one of these can be ignored when valuing a purchase vs. a lease?
-tax shield from depreciation
-investment outlay for the asset
-changes in operating costs related to the acquired asset
Leases can be setup solely to avoid taxes
One key reason why the IRS is concerned about the structure of lease contracts is because:
-firms that lease generally pay no taxes
-leasing usually leads to bankruptcy
-leases can be set up solely to avoid taxes
-leasing leads to off balance-sheet-financing
-lease payments can never be deducted as a business expense
A sale and leaseback
The city of Plainview sold its maintenance facility in an all-cash transaction and used the proceeds to improve the city's financial position. The city then leased the building from the new owner on a non-cancellable basis. The city will be responsible for the maintenance and upkeep of the facility. These transactions illustrate:
-an operating lease
-a leveraged lease
-a sale and leaseback
-a fully amortized lease
-both an operating lease and a sale and leaseback
A decrease in accounts receivable
Which one of the following will decrease net working capital of a firm?
-a decrease in accounts payable
-an increase in the firm's checking account balance
-a decrease in accounts receivable
-a decrease in fixed assets
-an increase in inventory
is frequently affected by the additional sales generated by a new project
Net working capital:
-requirements generally, but not always, create a cash inflow at the beginning of a project
-expenditures commonly occur at the end of a project
-is the only expenditure where at least a partial recovery can be made at the end of a project
-is frequently affected by the additional sales generated by a new project
-can be ignored in project analysis because any expenditures is normally recouped by the end of the project
wide range of values to multiple variables simultaneously
Simulation analysis is based on assigning a _____ and analyzing the results.
-wide range of values to a single variable
-narrow range of values to a single variable
-single value to each of the variables
-wide range of values to multiple variables simultaneously
-narrow range of values to multiple variables simultaneously
I, II, III, IV
Which of the following are examples of an incremental cash flow?
I. An increase in accounts receivable
II. A decrease in net working capital
III. An increase in taxes
IV. A decrease in the cost of goods sold
the interest expense is equal to zero
The bottom-up approach to computing the operating cash flow applies only when:
-no fixed assets are required for the project
-the project is a cost-cutting project
-both the depreciation expense and the interest expense are equal to zero
-taxes are ignored and the interest expense is equal to zero
-the interest expense is equal to zero
Marshall's & Co. purchased a corner lot in Eglon City five years ago at a cost $640,000. The lot was recently appraised at $810,000. At the time of the purchase, the company spent $50,000 to grade the lot and another $4,000 to build a small building on the lot to house a parking lot attendant who has overseen the use of the lot for daily commuter parking. The company now wants to build a new retail store on the site. The building cost is estimated at $1.2 million. What amount should be used as the initial cash flow for this building project?
direct labor costs
Which one of the following is most likely a variable cost?
-direct labor costs
degree to which the net present value reacts to changes in a single variable
Sensitivity analysis helps you determine the:
-degree to which the net present value reacts to changes in a single variable
-level of variable costs in relation to the fixed costs of a project
-net present value given the best and worst possible situations
-degree to which a project is reliant upon the fixed costs
-range of possible outcomes given possible ranges for every variable
Which of the following statements concerning variable costs is (are) correct?
I. Variable costs minus fixed costs equal marginal costs.
II. Variable costs are equal to zero when production is equal to zero.
III. An increase in variable costs increases the operating cash flow.
are constant over the short-run regardless of the quantity of output produced
-can be ignored in scenario analysis since they are constant over the life of a project.
-are constant over the short-run regardless of the quantity of output produced.
-change as the quantity of output produced changes.
-reflect the change in a variable when one more unit of output is produced.
-are subtracted from sales to compute the contribution margin.
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