Financial Decision Models

Question 1

What are the 3 stages of cash flows?

Answer 1

1. Inception of the project- both direct and indirect cash flow effects occur at the time of the initial investment:
   working capital requirements (may need to increase/decrease WC to ensure success of the project)

additional WC requirements- increase in payroll, expenses for supplies, or inventory requirements

reduced WC requirements- implementing a JIT inventory system represents a decrease in CA and recognized as an indirect cash inflow at inception

disposal of the replaced asset:
-asset abandonment
-asset sale

2. operations- will affect both direct and indirect cash flows of the company
3. disposal of the project- produces direct or indirect cash flows

Question 2

How do you calculate after-tax cash flows?

Answer 2

1. multiply net operating cash inflows by (1-t)
2. add the tax shield associated with noncash expenses such as depreciation (depreciation * t)
3. add the two together

Question 3

What are the 3 financing options and its implications?

Answer 3

1. Borrow to Buy- bank loan will be recorded in non current liabilities and will increase the firm’s debt to equity ratio. Interest on the debt will reduce the firm’s interest coverage ratio. the overall effect depends on the profits generated by the asset as these will increase earnings and equity.
2. Finance lease- a ROU asset and lease liability will be recognized on the BS of the lessee, and the debt to equity ratio would rise. Lease payments are split between interest expense and repayment of principal and therefore the liability is amortized over time, falling to zero. Interest expense in the early years is relatively high, decreasing the interest coverage ratio but int exp falls in later years as the liability decreases.
3. Operating lease- although the accounting treatment for op leases is similar to finance leases and the lease payments are recognized as lease expense on the IS, an entity may elect to not recognize the asset and liability if the lease term is 12 months or less and there are no purchase options associated with the lease that the lessee is reasonably certain to exercise.

Question 4

Uniform cash flows involve what 3 factors?

Answer 4

1. project evaluation- the net annual cash inflow would be the net cash receipts associated with the project
2. asset evaluation- in the case of purchasing equipment, the net annual cash inflow will be the savings generated by use of the new equipment
3. depreciation tax shield- dep exp is not considered, except to the extent that it is a tax shield

Question 5

What is the discounted payback method?

Answer 5

• computes the payback period using expected cash flows that are discounted by the project’s cost of capital
• considers the time value of money
• referred to as the breakeven time method (BET)

Question 6

What is the objective of the discounted payback method?

Answer 6

• to evaluate how quickly new ideas are converted into profitable ideas
  1. Focus on liquidity and profit- focuses decision makers on the number of years needed to recover the investment from discounted net cash flows

2. Evaluation term- computation begins when the project team is formed and ends when the initial investment has been recovered
3. Using discounted payback- used to evaluate new product development projects of companies that experience rapid technological changes. These companies want to recoup their investment quickly, before their products become obsolete