BEC 3.1

Question 1

Define sunk costs.

Answer 1

Costs that have already been incurred, are unavoidable in the future, and will not vary with the course of action taken

Question 2

What is the formula for after-tax cash flow?

Answer 2

(1.0 - Tax Rate) x Pre-tax cash flows = After-tax cash flow

Question 3

The forumla for computing a depreciation tax shield is:

Answer 3

Tax rate x depreciation deduction

Question 4

What are the three general stages in which capital investment cash flows are categorized?

Answer 4

1. Cash flows at the inception of the project
2. Operating cash flows
3. Cash flows from the disposal of the project

Question 5

What approaches can management take to select the desired rate of return for a project?

Answer 5

• Use a weighted average cost of capital (WACC) method
• Assign a target rate for new projects
• Recommend that the discount rate be related to the risk of the project

Question 6

Define net present value (NPV)

Answer 6

Difference between the present value of the cash inflows and outflows from a project

Question 7

How are investment decisions made using the NPV method?

Answer 7

• If NPV is positive, then the investment should be made.

- If NPV is negative, then the investment should not be made.

Question 8

What is the profitability index?

Answer 8

Ratio of the present value of net future cash inflows to the present value of the net initial investment.
The higher the profitability index, the more desirable the project.

Question 9

Define internal rate of return (IRR)

Answer 9

Discount rate at which the present value of the cash inflows equals the present value of the cash outflows from an investment/project

Question 10

How are investment decisions made using IRR?

Answer 10

When IRR exceeds the hurdle rate

Question 11

What is the payback method formula?

Answer 11

Payback period = Net initial investment / increase in annual net after-tax cash flow