lecture 4: chapter 8: Net Present Value and Capital Budgeting

Question 1

Incremental cash flows

Answer 1

the changes in the firm’s cash flows that occur as a direct consequence of accepting the project

Question 2

sunk cost

Answer 2

a cost that has already occurred

they cannot be changed by the decision to accept or reject the project

we should ignore such costs

Question 3

opportunity costs

Answer 3

by taking the project, the firm forgoes other opportunities for using the assets

what you potentially forego when making an action

Question 4

the side effects of the proposed project on other parts of the firm

Answer 4

erosion or synergy

Question 5

erosion

Answer 5

occurs when a new product reduces the sales and, hence, the cash flows of existing products

Question 6

synergy

Answer 6

occurs when a new project increases the cash flows of existing projects

Question 7

allocated cost

Answer 7

cash outflow of a project only if it is an incremental cost of the project

Question 8

Net working capital

Answer 8

the difference between current assets and current liabilities

Question 9

why is working capital usually negative in the beginnings of projects?

do companies usually recover it by the end of the project?

Answer 9

because of assumed expansion

–> we got more working capital that we must later repay

–> funded by cash generated elsewhere in the firm

–> Hence, these increases are viewed as cash outflows

yes they do

–> all inventory is sold by the end, the cash balance maintained as a buffer is liquidated, and all accounts receivable are collected

–> decreases in working capital in the later years are viewed as cash inflows

Question 10

increases in working capital in the beginnings of projects is because of what?

Answer 10

funded by cash generated elsewhere in the firm

–> Hence, these increases are viewed as cash outflows

Question 11

a firm’s management generally keeps which two sets of books

Answer 11

one for the CRA (called the tax books)

one for its annual report (called the shareholders’ books)

Question 12

when does an investment in net working capital arises?

Answer 12

(1) raw materials and other inventory are purchased prior to the sale of finished goods
(2) cash is kept in the project as a buffer against unexpected expenditures
(3) credit sales are made, generating accounts receivable rather than cash

–> This investment in net working capital represents a cash outflow, because cash generated elsewhere in the firm is tied up in the project

Question 13

the real interest rate

Answer 13

interest rate with inflation

real rate = (1 + nominal rate)/(1 + inflation rate) - 1

or it is approximately nominal rate - inflation rate

–> only works when the percentages are low

Question 14

nominal interest rate

Answer 14

no inflation considered

Question 15

when is a cash flow expressed in nominal terms?

Answer 15

whenthe actual dollars to be received (or paid out) are given

Question 16

when is a cash flow expressed in real terms?

Answer 16

when the current or date 0 purchasing power of the cash flow is given

future cash flow / (1 + inflation rate)^n

Question 17

Nominal cash flows must be discounted at which rate?

Answer 17

the nominal interest rate

Question 18

real cash flows must be discounted at which rate?

Answer 18

the real interest rate

Question 19

the bottom-up approach for operating cash flow

when is is only acceptable to use this?

Answer 19

find the net income, and then add back any non-cash deductions such as depreciation

only if there is
no interest expense subtracted in the calculation of net income

Question 20

the top-down approach for operating cash flow

Answer 20

Begin with the top of the comprehensive statement of income with sales, and work down to net cash flow by subtracting costs, taxes, and other expenses

Along the way, simply leave out any strictly non-cash items such as depreciation

Question 21

the tax shield approach for operating cash flow

Answer 21

(sales - costs) · (1 - tax rate) + Depreciation · tax rate

Question 22

the depreciation tax shield

Answer 22

Depreciation · tax rate

Knowing that depreciation is a non-cash expense, the only cash flow effect of deduct- ing depreciation is to reduce our taxes.

Question 23

the equivalent annual cost (EAC)

Answer 23

when we must choose between different projects, or equipment, or other expenses that have different lifespan (hence some have more outflows than others)

his approach puts costs on a per year basis

–> find the annuity per for the mount of years necessary equal to the PV of total cash outflows