chapter 14: Cash Flow Estimation and Capital Budgeting Decisions

Question 1

general guidelines for estimating the cash flows associated with capital expenditure decisions

Answer 1

1. Estimate all cash flows on an after-tax basis, because taxes can play an important role in any investment decision and because we use an after-tax cost of capital to discount these cash flows
2. Use the appropriate cash flow estimates that represent the marginal or incremental cash flows arising from capital budgeting decisions

–> includes the changes in existing flows that result from the firm’s decisions

3. Do not include associated interest and dividend payments in estimated project cash flows; they should already be accounted for in the discount rate
4. Adjust cash flows to reflect any additional working capital requirements that are associated with the project

–> represents a drain of cash that should be considered in the capital budgeting decision, because any funds that are tied up have an associated cost

5. Treat sunk costs as irrelevant; we are only concerned with future cash flows
6. opportunity costs should be factored into cash flow estimates
7. Determine the appropriate time horizon for the project
8. Ignore intangible considerations that cannot be measured in the financial analysis, unless their impact on cash flows can be estimated
9. Ignore externalities in the calculations
10. Consider the effect of all project interdependencies on cash flow estimates

–> Undertaking a project now could mean a negative NPV in the short term but might give the firm the option to do other things in the future that may generate value

11. Treat inflation consistently
12. Undertake all social investments required by law even if they have negative rates of return or no definable impact on the value of the firm

Question 2

marginal or incremental cash flows

Answer 2

the additional cash flows that result from capital budgeting decisions, generated by new projects

can be cash inflows and outflows

Question 3

sunk costs

Answer 3

costs that have already been incurred, cannot be recovered, and should not influence current capital budgeting decisions

Question 4

opportunity costs

Answer 4

cash flows that must be forgone as the result of an investment decision

Question 5

when are projects usually finished?

Answer 5

when it is economical to do so, not when the engineer says the assets are no longer functioning

Question 6

externalities

Answer 6

the consequences that result from an investment that may benefit or harm unrelated third parties

Question 7

three different categories of after tax cash flows

Answer 7

initial after-tax cash flow

expected annual after-tax cash flow

ending (or terminal) after-tax cash flow

Question 8

The initial after-tax cash flow (CF0)

Answer 8

refers to the total cash outlay that is required to initiate an investment project

includes additional cash flows, such as the change in net working capital (NWC) and associated opportunity costs

differs from the capital cost (C0) of an investment

Question 9

the capital cost (C0) of an investment

Answer 9

includes all costs incurred to make an investment operational

can be depreciated for tax purposes

not just the purchase price but also all other cash outlays that are needed to get the equipment operational

Question 10

The expected annual after-tax cash flows (CFt)

Answer 10

those that are estimated to occur as a result of the investment decision

comprise the associated expected incremental increase in after-tax operating income as well as any incremental tax savings (or additional taxes paid) that result from the initial investment outlay

Question 11

the capital cost allowance (CCA)

Answer 11

the amount of depreciation charged for tax purposes

Question 12

two ways to estimate cash flows using the CCA

Answer 12

1. deduct CCA from operating income, then deduct the associated taxes payable, and finally add the amount of the CCA expense back (because it is a non-cash expense)
2. recognize that CCA creates tax savings for the firm in the amount of the CCA expense multiplied by the company’s effective tax rate (T), which is then added to the after-tax operating income, determined by deducting the taxes associated with the firm’s before-tax operating income (before depreciation

Question 13

the estimated cash flows formula

Answer 13

CFt = CFBTt · (1 - T) + CCAt · T

CFt = expected yearly cash flow after tax at year t

CFBTt = cash flow before taxes

T the firm’s marginal (or effective) tax rate)

Question 14

what are the CCA rules for expected cash flow?

Answer 14

1. use the formula CFt = CFBTt · (1 - T) + CCAt · T
2. CCA expense is lower in year 1 because of the half-year rule, is highest in year 2, declines in year 3, and declines every year thereafter as the UCC continually declines
3. we could view cash flows as an annuity

Question 15

The ending (or terminal) after-tax cash flow (ECFn)

Answer 15

the total cash flow that is expected to be generated in the terminal year of a project, aside from that year’s expected after-tax cash flow

comprises the estimated selling or salvage value (SVn) of the asset

Question 16

salvage value (SVn) of the asset

Answer 16

the estimated sale price of an asset at the end of its useful life

Question 17

The amount by which the salvage value exceeds the UCC

Answer 17

CCA recapture

is fully taxable

Question 18

the amount by which the UCC exceeds the salvage value if the salvage value is less than the ending UCC

Answer 18

terminal loss

is fully tax deductible

Question 19

accelerated depreciation

Answer 19

a depreciation method that creates a higher depreciation expense in the earlier years and lower charges in the later periods

Question 20

expansion projects

Answer 20

projects that would add something extra to the firm in terms of extra sales or cost savings

the new cash flows that arise from the investment decision represent incremental cash flows

Question 21

Replacement projects

Answer 21

involve the replacement of an existing asset (or assets) with a new one

we must focus more on incremental cash flows than with expansion projects