BEC Unit 2 Module 8

Question 1

NPV

Answer 1

1. ) Estimate Cash Flows (Ignore interest and depr.)
2. ) Discount the cash flows
3. ) Compare PVs of inflows and outflows
   - - Positive Result (ROR is > than the hurdle rate or the discount percentage rate) = Make investment
   - - Negative Result = Do not make investment
   - -Diff. btwn inflows and outflows
   - -Theoretical dollar change in the market value of the firm’s equity due to the project

Question 2

Profitability Index

Answer 2

PV of cash flows / Cost of investment

• -The higher this index (usually over 1.0) the more desirable
• -Capital Rationing

Question 3

When estimating cash flow for use in capital budgeting, depreciation is used as:

Answer 3

Determining tax costs or benefit

Question 4

After-tax cash inflow

Answer 4

Cash inflows x (1 - tax rate) + (Depr. x tax rate)

Question 5

Disadvantage of Capital Budgeting Models

Answer 5

Reliance on future data

Question 6

Ordinary Annuity

Answer 6

End of year

Question 7

Ordinary Annuity DUE

Answer 7

Beginning of year

Question 8

Equipment-Replacement Decisions

Answer 8

• Current Disposal Price of old equipment
• Cost of new equipment
• Operating costs of new equipment

Question 9

Capital Budgeting

Answer 9

Long-term only

Question 10

Stages of Cash flows

Answer 10

1. ) Today’s cost outflow (initial cash outflow)
   - —-Acquisition cost of asset and indirect cash flow effects (working capital requirements or disposal of the replaced asset)
2. ) Operations (Future annual cash inflows)
   - —-Cash flows generated from the operations of the asset occur on a regular basis. May be the same every year or differ
   - —–Depreciation tax shields create ongoing indirect cash flow effects (Depr. x T = Inflow)
3. ) Disposal of Project - One time terminal year cash inflow (at END of project)
   - —–If asset is sold, there is a direct effect for the cash inflow created on the sale and an indirect effect for the taxes due (INFLOW)
   - —–Certain direct expenses (severance pay) (OUTFLOW)
   - —–Tax savings if asset is scrapped (INFLOW)
   - —–Decrease in Working Capital (INFLOW)

Question 11

Disposal of replaced asset

Answer 11

Cash proceeds on sale of old (net of tax)

–Cash inflow

Question 12

Cash Flow Effects

Answer 12

Direct Effect: When a company pays out cash, or receives cash
Indirect Effect: Noncash (depr.) Depreciation reduces the amount of taxable income. Reduced tax bill from increasing depreciation decreases the cash paid out

Question 13

Advantages of NPV

Answer 13

Flexible and can be used when there is no constant rate of return

Question 14

Limitations of NPV

Answer 14

Not providing the true rate of return

Question 15

Capital Rationing

Answer 15

Unlimited Capital
–All investments with a positive NPV should be pursued
Limited Capital
–Max NPV