Financial Decision Models

Question 1

What is evaluating and selecting the long-term investment projects of the firm called?

Answer 1

Capital budgeting

Question 2

No cash activity that produces cash benefits or obligations are considered what effect?

Answer 2

Indirect

Question 3

What are the three stages of cash flows?

Answer 3

1. Inception of the project
2. Operations
3. Disposal of the project

Question 4

How to calculate the disposal of a replaced asset?

Answer 4

Selling Price (inflow) - Net Book Value = G/L
G/L X Tax Rate = Taxes Paid (Outflow)
Selling Price - Taxes Paid = Net Gain or Loss

Question 5

Formula for calculating the After-Tax Cash Flows:

Answer 5

Pretax Cash Flow (EBT) x (1 - Tax Rate) = Inflow

Question 6

Formula for calculating depreciation tax shields:

Answer 6

Depreciation x tax rate = inflow

Question 7

The bigger the depreciation expense means…

Answer 7

The bigger the cash inflow / tax reduction

Question 8

Techniques that use time value of money concepts to measure the present value of cash inflows and outflows expected from a project are:

Answer 8

Discounted Cash Flow (DCF) Valuation Methods

Question 9

What is the objective of the Discounted Cash Flows (DCF) Valuation Methods?

Answer 9

To focus managements attention on relevant cash flows (after tax) appropriately discounted to PV

Question 10

Formula to calculate the NPV:

Answer 10

Sum of PV future cash flows - cost = NPV

Question 11

Formula to calculate interest expense:

Answer 11

EBIT X (1 - Tax Rate) = CFO

Question 12

The steps for calculating the NPV for discounted future cash flows are:

Answer 12

1. Calculate after tax cash flows = Net Cash Flows X (1 - Tax Rate)
2. Add depreciation benefit = Depreciation X Tax Rate
3. Multiply the result by appropriate present value of an annuity
4. Subtract initial cash outflow

The result of the above steps is the Net Present Value

Question 13

The theoretical dollar change in the market value of the firm’s equity due to the project is the

Answer 13

NPV

Question 14

If the NPV is positive, the sum of the PV FCFs is > the Cost, then the rate of return is greater than the hurdle rate (the discount percentage used in the net present value calculation) and the investment should be made or not made?

Answer 14

The investment should be made

Question 15

If the NPV is negative, the sum of the PV FCFs is < the Cost, then the rate of return is less than the hurdle rate (the discount percentage used in the net present value calculation) and the investment should be made or not made?

Answer 15

The investment should not be made

Question 16

Advantages and limitations to using the NPV Method:

Answer 16

Advantages: flexible and can be used when there is no constant rate of return required
Disadvantages: does not provide the true rate of return on the investment

Question 17

If capital is limited and must be rationed, management should

Answer 17

Allocate capital to the combination of projects with the maximum NPV

Question 18

The formula for calculating the profitability index is:

Answer 18

Present value of cash flows / cost (PV) of initial investment

(One hopes the profitability index is high)

Question 19

What are the two decisions when applying the NPV: Lease vs Buy Decision?

Answer 19

Investment decision or Financial decision

Question 20

Under the investment decision, one would discount the after-tax operating cash inflows at what rate?

Answer 20

The firms’s weighted average cost of capital (WACC) rate

EBIT X (1 - Tax Rate)

Question 21

Under the financial decision, one would discount the cash flows using what rate?

Answer 21

At the after-tax cost of debt

YTM X (1 - Tax Rate)

Question 22

Under the financial decision, which financing option is the preferred option?

Answer 22

The one with the lowest NPV

Question 23

As a company’s debt to equity ratio increases, it will appear to be more risky and do what to their credit rating?

Answer 23

Cause their credit rating to decrease

Question 24

The expected rate of return on project is also called what?

Answer 24

The internal rate of return (IRR)

If the IRR > Hurdle Rate, accept the project

Question 25

The time required for the net after-tax operating cash inflows to recover the initial investment in a project is called the:

Answer 25

Payback period

Question 26

The payback period method focuses decision makers on what?

Answer 26

Liquidity and risk

It is used for risky investments. The greater the risk of the investment, the shorter the payback period that is expected/tolerated by the company.

Question 27

Calculation for finding the payback period is:

Answer 27

Initial investment / annual annuity = payback period

The lower the payback period the better

Question 28

What are some limitations to the payback period method?

Answer 28

Time value of money is ignored
Cash flows occurring after the initial investment is recovered are ignored
Reinvestments of cash flows is ignored
Profitability is ignored

Question 29

The major difference between the payback period method and the discounted payback period method is what?

Answer 29

The discounted payback period method incorporated the time value of money in its calculation