Chapter 10

Question 1

What are incremental cash flows?

Answer 1

The incremental cash flow 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.

Question 2

Any cash flow that exists regardless of whether or not a project is undertaken is __________.

Answer 2

not relevant

Question 3

What is the stand-alone principle?

Answer 3

The assumption that evaluation of a project may be based on the project’s incremental cash flows.

Question 4

What is a sunk cost?

Answer 4

A cost that has already been incurred an cannot be removed and therefore should not be considered in an investment decision.

Question 5

What is an opportunity cost?

Answer 5

The most valuable alternative that is given up if a particular investment is undertaken.

Question 6

What is erosion?

Answer 6

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

Question 7

Erosion is relevant only when the __________ would not otherwise be lost.

Answer 7

sales

Question 8

So the firm’s investment in project net working capital closely resembles a _________.

Answer 8

loan

Question 9

Our goal in project evaluation is to compare the __________ from a project to the __________ that project in order to estimate NPV.

Answer 9

cash flow

cost of acquiring

Question 10

What are pro forma financial statements?

Answer 10

Financial statements projecting future years’ operations.

Question 11

To prepare pro forma financial statements, we will need the following:

Answer 11

1. unit sales
2. selling price per unit
3. variable cost per unit
4. total fixed costs
5. total investment required

Question 12

While preparing the pro forma financial statement, we do not deduct any __________ because it is a financing expense, not a component of operating cash flow.

Answer 12

interest expense

Question 13

Cash flow from assets has three components:

Answer 13

1. operating cash flow
2. capital spending
3. changes in net working capital

Question 14

How do we calculate Project Cash Flow?

Answer 14

Project Cash Flow = Project Operating Cash Flow - Project Change in Net Working Capital - Project Capital Spending

Question 15

How do we calculate Operating Cash Flow?

Answer 15

Operating Cash Flow = Earnings Before Interest and Taxes (EBIT) + Depreciation - Taxes

Question 16

Whenever we have an investment in net working capital, that same investment has to be __________.

Answer 16

recovered

Question 17

How do we calculate Average Accounting Return (AAR)?

Answer 17

AAR = Average Net Income/Average Book Value

Question 18

What is the accelerated cost recovery system (ACRS)?

Answer 18

A depreciation method under U.S. tax law allowing for the accelerated write-off property under various classifications.

Question 19

An increase in net working capital (NWC) is a cash __________, so we use a __________ sign to indicate an additional investment that the firm makes in net working capital.

Answer 19

outflow

positive

Question 20

What is the bottom-up approach?

Answer 20

To project Operating Cash Flow, We start with the accountant’s bottom line (net income) and add back any non-cash deductions such as depreciation. (OCF = Net Income + Depreciation)

Question 21

The definition of operating cash flow as net income plus depreciation is correct only if there is no __________ subtracted in the calculation of net income.

Answer 21

interest expense

Question 22

What is the top-down approach?

Answer 22

To project Operating Cash Flow, we start out at the top of the income statement with sales and work our way down to net cash flow by subtracting costs, taxes, and other expenses. (OCF = Sales - Costs - Taxes)

Question 23

What is the formula for the tax shield approach?

Answer 23

OCF = (Sales - Costs) x (1 - T) + Depreciation x T

Question 24

What are the two components of the tax-shield approach?

Answer 24

1. Calculate the project’s cash flow without depreciation expense
2. Depreciation deduction multiplied by the tax rate (T)

Question 25

What is the depreciation tax shield?

Answer 25

The tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate.

Question 26

What is the equivalent annual cost (EAC)?

Answer 26

The present value of a project’s costs calculated on an annual basis.

Question 27

Frank’s is a furniture store that is considering adding appliances to its offerings. What would be the best example of an incremental cash flow related to appliances?

Answer 27

Selling furniture to appliance customers

Question 28

Changes in the net working capital requirements:

Answer 28

can affect the cash flows of a project every year of the project’s life

Question 29

A company that utilizes the MACRS system of depreciation will have a greater depreciation tax shield in year ____ than in year ____.

Answer 29

2

1

Question 30

What is a relevant cash flow?

Answer 30

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.