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Finance exam number 4
Chapter 9 concepts
Terms in this set (41)
is the process of planning for purchases of assets whose returns are expected to generate a flow of future cash benefits lasting longer than one year.
is a cash outlay that is expected to generate a flow of future cash benefits lasting longer than one year.
Why should cash flows be measured on an incremental basis?
to isolate the effect of ONE project will have financially
Firms cost of capital =
investors required rate of return (on its securities) - cost of company b/c HAVE TO pay it out.
acceptance or rejection does not directly eliminate other projects
mutually exclusive projects
is one projects acceptance will preclude the acceptance of another project. ONE project must be chosen and the other is denied
the acceptance is dependent on the adaption of another project
setting limits on capital expenditures bc of funds constraints of company.
examples of mutually exclusive projects
new machine, used machine, rent a machine, or repair an old one must pick one!
Two kinds of capital budgeting
Marginal Cost of Capital and Investment Opportunity Curve
Marginal Cost of Capital (MCC)
Cost of successive increments of capital (with loans and securities)
Investment Opportunity Curve
expected rate of return on the successive increments of capital acquired by the firm (descending )
How are capital projects picked with the IOC and MCC chart?
ones to the left of the intersection of the two
Issues with Capital budgeting
1. All projects not known at one time
2. difficulty determining the shape of the MCC
3. Estimates of cash flows have varying degrees of uncertainty
What are the steps in the capital budgeting process?
1. generate the proposals
2. estimate the cash flows
3. evaluate the alternatives and and select the projects to do
4. reviewing the project after it has been implemented and post auditing
1. generated by growth opportunities
2. gen by cost reduction opp
3. generated by legal requirements and health and safety standards
what you are initially paying into the project ( cash outflow)
one negative and then positive for the rest- one change of cash flows in the beginning (always expecting money coming in)
non normal project
cash flows do not change direction or change direction several times ( negative and positives)
principles of estimating cash flows
on an incremental basis
on an after tax basis
include indirect effects
exclude sunk costs
opp costs should be considered
estimated how the entire cash flow stream of the firm will be
what are sunk costs?
costs that would be with or with out the project
cash flows of resources could generate if they are not used on the project considered
Estimating the NINV
1. cost + installation and shipping +
2. increase in net networking capital -
3. Net proceeds form sale of existing assets +/-
4. taxes associated with above sale = Ninv
net cash flow=
OEAT+DEP-NWC (change of)
book value =
original cost -dep
book sale=book value
no tax consequences
sale < book value
tax savings =marginal tax rate *amount of loss
sale >book value
tax liability =gain *marginal tax rate
sale > cost
tax liability =(gain + capital gain) *marginal tax rate
recovery the working capital
recovered at the end of project and decrease in net working capital means an increase in net cash flow
why is it incorrect to deduct interest charges from a project?
1. is how the firm is financed and should be done separately
of the projects
2. the cost of capital already incorporates the cost of funds to finance the project
what kind of depreciation should be used in net operating cash flows?
MACRS-Modified accelerated cost recovery system (finding taxable income)
asset expansion project
requires a firm to to invest funds in additional assets in order to increase sales
calculating the net investment for expansion projects
purchase price of equip+shipping and instillation +initial net working capital required =ninv
asset replacement project
retiring one asset and replacing it with a more efficient asset
net inv for replacement projects
cost+shipping and instillation
calculating annual net cash flows
salvage value and tax on salvage value
problems with estimating cash flows
1. difficult to do
2. may vary in uncertainty
why does cost of capital also a required rate on return?
bc it specifies the the minimum necessary rate of return required by the firms investors on new investments.
what tax effect results in selling an asset for price above orig cost?
capital gain tax and original income tax
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