Midterm 4 Part 2 Flashcards
When you have a taxable gain, did you over-depreciate or under-depreciate your asset?
Over-depreciated
When you have a taxable loss on the sale of assets, did you over or under depreciate that asset?
Under depreciated
If you have a tax gain, do you owe the government more or less taxes?
MORE
If you have a tax saving, do you owe the government more or less in taxes?
LESS
True or False: Taxable gains are ordinary taxable income (unless it’s real estate)
True
What are the three steps of capital budgeting?
- Evaluate the cash flows
- Assess project risk
- Accept or reject the project
True or False: For most projects, there are AT LEAST 3 types of cash flows
True
What are the three distinct types of cash flows?
- IO
- Annual or Differential cash flows
- Terminal cash flows
What are differential cash flows?
Cash flows accumulated during the life of the project.
Calculated annually. They represent the cash flows from the operations of the project EACH YEAR.
What are terminal cash flows?
Cash flows at the end of the asset’s useful life
What is the accounting rule regarding depreciable assets?
Any cost incurred in order to acquire and start using the asset is a capital expense, and therefore, depreciable
True or False: Employee training counts as a capital expense
True
True or False: When calculating the net IO, you must ALWAYS include the after-tax proceeds from sale of old assets
False
Only when you are replacing an old asset
True or False: Differential cash flows are the sum of each year of cash flows
TRUE
That’s why they’re also called annual CF
Define Free Cash Flow in terms of capital budgeting
Refers to the cash flow generated after funding increased working capital needs and required capital expenditures - forecasting FUTURE cash flows
(as opposed to FCF using historical data)
True or False: DIfferential cash flows need to be large enough to be worth investing in the project, they need to be larger than our investment or the NPV will be negative
TRUE
What is a depreciation reversal?
It is when we are calculating our differential cash flows. We subtract off the annual depreciation and then add it back after we calculate taxes.
Why do we do a depreciation reversal?
Because it minimizes the taxes we pay.
You take it off to reduce the taxable income you have. But then you add it back later (after taxes) to accurately show your cash flows.
What does it mean to recapture our net working capital?
That’s when you get rid of all the extra NWC that you accumulated at the beginning of the project, either by liquidating assets or changing your contracts.
True or False: You can use the firm’s cost of capital as the discount rate if you’re assuming that the risk of the project is the same as the risk of the overall firm.
True
True or False: Increases in NWC are depreciable
False
True or False: Increases or Decreases in NWC impact our taxes
False
True or False: When using the straight-line depreciation method, the differential cash flows will be the same every year?
TRUE
True or False: When you’re calculating the depreciable basis (to use in the straight line or simplified straight line method), you need to include your change in NWC
FALSE
DO NOT include the NWC in your calculation of your depreciable expenses. ONLY include the NWC in your calculation of IO
Why do we calculate the annual depreciation expense if it is a non-cash expense (something that we don’t have to pay out)?
For tax purposes.
If our depreciation method determines that our asset will reach 100% depreciation after 5 years, does that mean we will not be able to get anything back for it (by selling it) after those 5 years?
NO! Because our depreciation method is just an ESTIMATION of depreciation for accounting purposes (to estimate taxes) and will not always match the true market value.
Do depreciation calculations apply to current expenses or capital expenses?
Capital expenses.
Current expenses are gone by the end of the year anyway, so they don’t depreciate over time.
Is the half year convention the same as the half year assumption?
Yes
What are the three primary ways to value a firm?
- Replacement cost
- Discounted Cash Flows
- Comparable multiples
What is the idea behind the replacement cost method?
Trying to determine what it would cost to start the company over from scratch TODAY
Is it more difficult to value tangible or intangible assets when using the replacement cost method?
Intangible.
For all tangible assets on the balance sheet, you can determine an appropriate market value to plug into the replacement cost method. But it’s hard to put a price on an intangible asset (such as the reputation of the firm).
True or False: Valuing intangible assets using the replacement cost method is subjective.
True.
They’re hard to value, and the replacement cost value needs a set number to “replace” the assets on your balance sheet
True or False: The replacement cost method takes both sides of the Balance Sheet into account, and tries to determine how to replace both assets and liabilities.
TRUE
True or False: The right hand side of the balance sheet assesses the capital structure of the firm
True
What is a strength of the replacement cost method?
It is intuitive. You basically just add up the market values on both sides of the balance sheet to see how much it would cost to replicate them.
What is the primary weakness of the replacement cost method?
It’s difficult to value intangible assets, and the replacement cost method doesn’t take this into account.
What is a simple definition for the replacement cost method?
This method attempts to determine the cost of replacing the assets, liabilities, and equity of the firm by assigning each side of the balance sheet a “market value”
True or False: The replacement cost method work better for firms with many tangible assets
TRUE
The more tangible, the more accurate
True or False: The value of any asset is only equal to the present value of its future cash flows
TRUE
What does the numerator represent in the DCF equation?
Some measure of cash flow at some point in time
What does the denominator represent in the DCF equation?
The discount rate that corresponds to the cash flow in the numerator (the cash flow that is defined by a specific time)
What is the most popular dividend discount model?
Gordon Growth model
What are free cash flows to the firm?
It is the cash we have left over (after operations are paid out) BEFORE we pay money to lenders or owners/shareholders.
Where do you get the EBIT for the DCF model?
PnL or Income Statement
Where do you get the Depreciation charge for DCF model?
PnL or Income statement
Where do you get the cash tax payments for DCF model?
PnL or Income Statement
Where do you get the changes in NWC for DCF model?
You compare the changes in CA - CL from two balance sheets
Where do you get CAPEX for the DCF model?
You calculate the changes in capital expenditure from two balance sheets
Where do you get all the information for the DCF model?
From the Income statement and balance sheet
What are the two main types of free cash flows?
FCFF and FCFE
What is another name for principal debt payments?
Debts due
Why do we use WACC as the discount rate when using FCFF in the DCF model?
Because WACC takes both debt and equity into account.
Free cash flow to the firm is calculated BEFORE giving money to both creditors and shareholders (debt and equity), and WACC accounts for both of those.
What is the difference between FCFE and FCFF?
FCFF is calculating the free cash flow before BOTH debt and equity. FCFE is only calculating free cash flows before equity? I think
What are pro forma statements?
They are future projections based on past statistics and future plans.
What are the 5 steps to applying DCF to value the firm?
- Construct pro forma statements 3-5 years into the future
- Compute the FCF for each of these projected years
- In the last year, estimate a Terminal value and add it to the FCF that year
- Compute an appropriate discount rate
- Use TVM to discount all FCF to PV
True or False: Forecasting requires estimating a growth rate of sales
True
What are the two ways to estimate a terminal value for the firm?
Constant growth or no-growth models
What is another name for the constant growth model?
GGM
What does K subscript cf mean?
Cost of capital
What would Kcf equal if we are using a no-growth model?
0… because it isn’t growing
What is a “steady state”?
Growth becomes steady and the firm no longer grows at all. They are not bringing in any additional profits/value each year, no competitive advantage.
What is the assumption you must understand in step 4 of the DCF calculation?
You need to decide whether or not you think the firm is going to continue growing at a constant rate, or slow down and enter a “steady state”.
True or False: When a company reaches a “steady state” the growth rate is 0
True
True or False: The PV is the intrinsic value of the firm.
True
True or False: When it comes to personal finance, all finance professionals are unanimous on strategy
False
True or False: Brau wants you to always maintain your integrity when buying, selling, and negotiation
TRUE
Examples of online resources to help value your car
Consumer reports, edmunds, nada, kbb
When first looking into buying a house, what is one of the first questions you need to ask yourself?
Should I rent or should I buy?
True or False: When buying a car, you should shop around in different city locations
True
Why is it good to shop around different geographical locations for a car?
Because some cities will have better deals on the same style car. It depends on how much competition there is in that area.
True or False: It’s better to shop on the last day of the month
TRUE
Companies are trying to reach quotas
True or False: It’s best to shop on the last day of the quarter
TRUE
Companies are trying to reach quotas
True or False: Brau’s idea of “integrity” includes being a little sneaky, pointing out flaws of the car you like to try to get a better deal, not telling them which car you like, and tell them it will be a “stretch” to buy the car that you’ve pre-chosen
True
C’mon Brau
What are stall tactics?
They are tactics of the sales person designed to put pressure on the buyer to buy without thinking
Impulse buyers
People that buy without thinking, doing research, or negotiating
What do KBB (Kelley blue book) and Edmunds do?
They provide fair market values and trade in values of cars
What is a dealer’s invoice?
It is the price that the dealer paid to buy the car from a manufacturer
What does it mean to “sell/buy at invoice?”
It means that the dealership is willing to buy your car or sell you a car at the invoice price. This is usually when they’re desperate and not able to negotiate.
True or False: Invoice price is the best deal
TRUE
True or False: KBB will tell you what the invoice price is
True
True or False: It’s best to buy cars in cash whenever possible
True
Why is it helpful to bring your financial calculator to the deal?
So that you can calculate monthly payment, negotiate your rate, and check PV and FV
True or False: Car salespeople will NOT sell you the car unless they want to.
True
True or False: It’s in the car salespeople’s best interest to sell you the car
True
(usually, if you’re reasonable)
True or False: You should start your offer high and lower it when negotiating
FALSE
You should start low and NEVER go lower
True or False: It’s harder to negotiate when buying used cars
Trick question, it depends on where you are. Used car dealers may be more motivated than new car dealers, but the cars are also not worth as much.
Is it better to buy new or used?
Usually it’s better to buy used. New cars have a huge premium (because the idea that it’s “new” can be valued, intangible asset)
But if you WANT a new car, you can buy whatever you want.
Used cars also don’t depreciate as quickly. You lose thousands of dollars driving off the lot with a new car.
True or False: If you’re trading in a car, you should wait to tell the dealer until you’ve set a price for the new car
True. You can get a higher trade in value this way
Why could you get a better trade in value for your car if you wait to negotiate that price until AFTER you’ve negotiated the price of the new car?
Because the dealer has already spent a lot of time negotiating the other price, they don’t want to lose this sale.
True or False: If the dealership asks you about a trade in right up front, you should lie
FALSE
Don’t lie, just tell them you aren’t sure if you’re trading in your car or selling it. Tell them it depends on the price they offer.
True or False: You will almost always get a better price selling the car than trading it in
TRUE
Put that thing on Craigslist if you have the time and patience
Why do people trade in instead of sell their old cars if you can make more money selling them?
Because it’s super convenient.
Why is it valuable to buy good home-buyer’s books?
So that you can EDUCATE yourself on the process (which can be scary) and get the best deal possible
What was the book that Brau recommends buying to get educated about the real estate market?
The Complete Guide to Buying Your First House by Woodson
Should you buy the Woodson book?
Probably not. It’s a little out of date, out of print, and might not reflect your own home buying goals
What is the first most important step of buying a house?
Buying a book that teaches you how to buy a house
How many years do you typically have to live in a house in order to break even on the transaction costs?
3-5 years
True or False: You should always buy a house
False
There are a lot of reasons that it might be better to rent.
What are some reasons why you should rent instead of buy a house?
If you won’t be living there for long, pre-furnished convenience, insurance is cheaper, overall cost is cheaper, upkeep is cheaper and you don’t have to do maintenance yourself
What are some reasons why you should buy a house instead of renting?
Equity?
Customize it, ownership and pride in that ownership, borrow against your house,
