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Finance 201 > Midterm 4 Part 1 > Flashcards

Midterm 4 Part 1 Flashcards

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1
Q

True or False: Number-crunching makes decisions.

A

FALSE
There are many factors to consider when weighing project options.

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2
Q

What is a quantitative analysis vs. a qualitative analysis?

A

Qualitative is just focusing on money and numbers, meaning that as long as the basic decision rules are met, the project should be accepted.

But Qualitative analysis shows us that there are other factors that matter (that cannot be calculated) when determining if a project should be accepted.

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3
Q

Examples of qualitative factors

A

Employment (if the project would cost people their jobs), stakeholders, ESG, public interest, etc.

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4
Q

What does ESG stand for?

A

Environmental social governance.

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5
Q

What is ESG?

A

Basically it means actions companies take to remain socially and environmentally responsible.

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6
Q

Examples of Quantitative factors

A

IRR, MIRR, Payback method, Discounted payback method, NPV, AARR, PI

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7
Q

What is the discounted payback method and how is it different than the regular payback method?

A

It’s calculated exactly the same, except that instead of just subtracting the face value of Cash Flows, you discount each cash flow back to PV and THEN subtract them from the IO.

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8
Q

What is the Treynor Ratio?

A

(Return - Risk Free Rate) /
Beta

It is basically the Sharpe ratio, but over Beta instead of Standard deviation

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9
Q

What is variance?

A

It is standard deviation but before you take the square root.

Essentially it is sigma squared. σ^2

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10
Q

What does AARR stand for?

A

Average accounting rate of return

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11
Q

True or False: AARR is another method similar to IRR and NPV used to determine if a project is acceptable

A

TRUE

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12
Q

What is the AARR formula?

A

Average net income / Average book assets

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13
Q

What is the AARR decision rule?

A

If the AARR is greater than the target ROA, accept the project

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14
Q

True or False: It’s important to do the number crunching in addition to qualitative analysis.

A

TRUE

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15
Q

What’s another name for qualitative analysis?

A

Big picture analysis

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16
Q

Quantitative and qualitative analysis are both part of what larger process?

A

Capital budgeting

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17
Q

Examples of different types of cash flows

A
  1. Incremental cash flows
  2. Incidental Cash flows
  3. Sunk costs
  4. Opportunity costs
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18
Q

Why is it important to determine which cash flows to attribute to a project and which to ignore?

A

Because they help you determine the project’s value.

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19
Q

What is the basic definition of incremental cash flows?

A

The basic cash flows that are directly tied to the project we are about to accept / reject

These cash flows would not occur otherwise.

NOTE: These are both in and out of the firm

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20
Q

What are three specific assets of almost any capital project?

A

Depreciation
Taxes
Working capital changes

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21
Q

Examples of things that could be considered incremental cash flows

A

Any additional revenue, taxes, expenses, or other costs of accepting the project

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22
Q

True or False: Sunk costs matter in our analysis of cash flows

A

False. They’re irrelevant

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23
Q

The net incremental cash flow equals what?

A

The sum of all incremental cash flows (incremental cash IN minus incremental cash OUT)

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24
Q

True or False: Non-incremental cash flows should be excluded

A

TRUE

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25
Q

What does it mean for a cost to be non-incremental?

A

It means that the company will incur that cost, whether they accept the project or not.

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26
Q

Why do we do capital budgeting?

A

Because we want to understand the overall impact of a new project on our company.

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27
Q

Why don’t we include non-incremental cash flows in our analysis?

A

Because they are irrelevant or redundant (or both).

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28
Q

Other than providing irrelevant information, why do we only include incremental cash flows in our analysis?

A

Because it prevents accountants from assigning overhead costs to the project (costs that would have been incurred regardless of accepting the project)

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29
Q

What are the 2 Essential Guidelines when considering which cash flows to include in analysis?

A
  1. Look at Big Picture as a CEO, not a number cruncher
  2. There will always be people trying to allocate cash flows (especially expenses) to your project.
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30
Q

What are incidental cash flows?

A

They are cash flows that are created by a new project, but are not explicit revenues or costs.

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31
Q

What is the difference between direct and incidental revenue?

A

Direct revenues would be the immediate sales of the product (as an example), but incidental revenues come as a result of selling the product.

Tuna Fish example: The store is selling tuna for 59 cents even though it costs them 70 cents to make. They are losing 11 cents per can of tuna, BUT, they are counting on the incidental costs of people buying tuna fish AND bread, celery, or mayo.

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32
Q

Cannibalism

A

When a product sees a decrease in sales because of the launch of a new product that was introduced by the same company.

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33
Q

How does cannibalism relate to incidental cost?

A

The sales lost by the cannibalized product should be considered incidental cash flows of the new product.

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34
Q

True or False: Cannibalized cash flows are always counted in incidental analysis

A

False.

It depends on the circumstances. Example: New Intel chips replacing the old ones. They don’t count that as money lost because no matter what they do, the sales of the old one will fall (the timing will just be different).

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35
Q

True or False: Cannibalized cash flows will USUALLY be counted towards your incidental analysis

A

True.
There are exceptions, but usually you want to include the lost sales as part of your capital budgeting decision.

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36
Q

What is a sunk cost?

A

A cost that has already been incurred and can’t be regained in the future.

It’s already in the past, you can’t change it.

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37
Q

Example of sunk cost

A

You bought a movie ticket for $10, but somebody offers you a free ticket for another movie.

If you choose to go to the $10 movie, you’re letting the sunk cost influence your decision making (which is bad). The $10 is spent, there’s nothing you can do, so you should just go to the movie that you WANT to go to.

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38
Q

What is the most important thing to remember about sunk costs?

A

THEY ARE IRRELEVANT to your decision making. What’s done is done, if the project is a waste of money, if it’s NOT going to be successful, then it’s a sunk cost and you should use your future money elsewhere.

Just think of Venture Data switching programs and then pulling out later. The money they spent was a sunk cost, but Jeff knew that any future money spent on it would be useless.

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39
Q

True or False: When dealing with sunk costs, all we care about is the money being spent in the future.

A

True, we care about future money and whether or not it’s going towards a good project or a bad project.

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40
Q

What is an opportunity cost?

A

It’s the cost of using your assets towards one project and NOT being able to use those same assets for another project.

You are giving up one benefit to get another benefit. The one you’re giving up is the opportunity cost.

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41
Q

Example of opportunity cost

A

If you’re starting a new business, you’re giving up the salary of your regular job.

42
Q

True or False: If we use land we already own for a project, we have to include the opportunity costs of that land into our analysis

A

TRUE
If you’re using the land for one project, you can’t use it for something else.

43
Q

Examples of assets that can have an opportunity cost

A

Land, cash, equipment, or even time

44
Q

What are the two methods for evaluation depreciation expenses

A
  1. MACRS
  2. Straight-line
45
Q

What does MACRS stand for

A

Modified accelerated cost recovery system

46
Q

What are the two kinds of expenses according to accounting?

A

Current expenses and capital expenses.

47
Q

What are current expenses?

A

Outlays (money spent on something) for goods and services that will be used during the current year.

48
Q

What is an outlay?

A

It is the initial money we spent on something

49
Q

What are capital expenses?

A

They are outlays for items that will provide a benefit to the firm over many years

50
Q

Example of a current vs. capital expense

A

If you buy a car:
Gas = current expense
The car itself = capital expense

51
Q

True or False: Capital expenses flow directly to the income statement

A

FALSE, they do NOT!

52
Q

Where are capital expenses included on the balance sheet?

A

As assets

53
Q

What is the cost associated with the decline of value of an asset (such as an automobile) during the year?

A

A depreciation expense

54
Q

Where is the depreciation expense included on an income statement?

A

Operating expense

55
Q

Do we calculate the exact value of a depreciation expense (an asset’s decay) or an estimation?

A

Estimation

56
Q

Why do we calculate DE if it’s not exact?

A

Because it impacts the taxes we pay.

It reduces our taxable income and therefore, our tax bill.

57
Q

True or False: Taxes are a real cash outflow

A

True

58
Q

Which system is better: MACRS or straight line?

A

MACRS

59
Q

Which system of depreciation estimation is called the “accelerated” depreciation system?

A

MACRS

60
Q

What is the depreciable basis?

A

The cost of the asset used in MACRS

61
Q

Who determines the percentage your asset should be depreciating each year?

A

The U.S. government

62
Q

How is the percentage of your asset’s depreciation calculated?

A

It’s calculated according to its estimated life. Assets fall into certain categories depending on their estimated life, each category has a different percentage assigned to it.

63
Q

Why is MACRS better than Straight line?

A

Because it’s super easy to apply and very simple to understand

64
Q

MACRS formula (different than card)

A

Annual depreciation expense = depreciable base x MACRS %

65
Q

True or False: The depreciable basis is the same as the cost of the asset (IO)

A

TRUE

66
Q

True or False: Each asset-life category will have one extra year before the asset is fully depreciated

A

TRUE

67
Q

What does it mean that each asset will have one extra year of depreciation according to the MACRS schedule?

A

It means that if you have an asset in the 3 year category, it will actually take 4 years to depreciate 100% of the way down to 0.

10 year asset would take 11 years

5 year asset would take 6 years, etc.

68
Q

What is the half-year assumption?

A

It is the assumption used in the MACRS equation that creates an “extra” year of depreciation.

Basically it assumes that the first and last years are both actually “half years” instead of full. So it APPEARS that the schedule is longer than the asset life, but that’s not true.

For example: If you were looking at a 3 year asset schedule, the first and fourth years would actually be considered “half years” and the second and third years would be full. So you would have 0.5 + 1 + 1 + 0.5 = 3

69
Q

What is the variation of the straight line depreciation method?

A

The simplified straight line depreciation method

70
Q

What is the SIMPLIFIED straight line depreciation method?

A

It basically assumes that the asset has zero salvage value.

71
Q

Which depreciation expense evaluation method assumes the salvage value is zero?

A

Simplified straight line depreciation method

72
Q

True or False: If an asset has a salvage value of 0, it will be considered worthless at the end of its life

A

FALSE
Not necessarily.

73
Q

What is an advantage of the straight line method?

A

The depreciation expense is the same every year of the asset’s life (instead of being dependent on a different percentage each year)

74
Q

Why is MACRS preferred?

A

Because it depreciates assets more quickly

75
Q

Why is MACRS considered accelerated?

A

Because it depreciates assets more quickly

76
Q

Why do we want a faster depreciation?

A

Because it changes the timing of the depreciation. This matters when we consider TVM. Depreciation expenses affect taxable income; the more depreciation expense we have, the lower our taxable income.

With MACRS, we have greater depreciation expense in the early years, which makes our taxes smaller in the early years. This keeps more money in our pocket TODAY, even though we eventually pay the same amount in taxes using either method. (The same amount in taxes, but NOT according to PV)

77
Q

True or False: The PV of our total tax bill over the life of the asset will be smaller with MACRS

A

True

78
Q

Why is our total tax bill smaller with MACRS?

A

Because if the majority of the taxes are happening later in the assets life, they are discounted back more heavily and will end up being less.

79
Q

True or False: Depreciation is a non-cash expense

A

TRUE

80
Q

Why is depreciation a non-cash expense?

A

Because it’s not something we write a check to, it’s just a system that calculates the cost of capital over time and affects our taxes.

81
Q

Why do we care about this non-cash expense when estimating cash flows and doing capital budgeting?

A

Because depreciation impacts the amount and timing of tax payments.

82
Q

What is working capital?

A

Capital needed to function day to day

83
Q

What is net working capital?

A

It is current assets minus current liabilities

84
Q

Why is net working capital important to calculate when capital budgeting?

A

Because sometimes you may need to increase it (your inventory and accounts receivable) at the start of a project

85
Q

True or False: Net working capital represents an increase in assets

A

TRUE

86
Q

What does the balance sheet equation tell us?

A

All assets must be financed.

87
Q

What is a safety stock

A

Putting raw materials or other inputs (to your assets) on hold, like having a backup of stock in case of crisis

88
Q

What is the Standard Convention of net working capital?

A

Increases in net working capital represent cash OUTFLOWS EARLY in the project and cash INFLOWS at the END of the project.

At time 0, we invest greater working capital (meaning we have more cash outflows), but at the end of the life of the project, we decrease working capital to its previous level, liquidating net working capital and recouping our original investment.

89
Q

What is the rule of net working capital

A

Regardless of how it is accumulated, any net working capital associated with a specific project needs to be liquidated at the end of the project’s life to result in cash INFLOWS.

90
Q

True or False: There are tax effects associated with working capital build-up or liquidation

A

FALSE

91
Q

Why must you liquidate all net working capital associated with the project at the end of its life?

A

Because otherwise you won’t get the money back that you spent increasing NWC at the beginning of the project.

92
Q

What are the two tax impacts of capital budgeting?

A
  1. Income taxes (usually marginal rate)
  2. Taxes on the sale of assets
93
Q

What is the tax rule of calculating book value?

A

If BV < sale price, then there is a taxable gain

If BV > sale price, then there is a taxable loss

94
Q

What is a marginal tax rate?

A

It’s usually a firm’s fixed tax rate

95
Q

What do you have left after you take out the taxes?

A

Net income

96
Q

Tax Shield

A

Offsetting positive earnings with negative income

Called a shield because the negative income shields the company from paying at least part of the taxes it would have otherwise paid).

97
Q

What is the tax rule of taxes on the sale of an asset?

A

Taxes are on asset GAINS, not revenues

98
Q

True or False: When you sell an asset for any amount other than its book value, there will be tax consequences

A

TRUE

99
Q

True or False: When you sell an asset at a loss, you save money in taxes

A

True

100
Q

True or False: Companies purposely sell assets at a loss to avoid taxes

A

False

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