Module 7 (Accounting for the Future) Flashcards
A company is considering investing in a new project with infinite life. The estimated cash flows of the first five years of the project are shown as below: Cash Flows 2021: $650 Cash Flows 2022: $1240 Cash Flows 2023: $2250 Cash Flows 2024: $3670 Cash Flows 2025: $4200
After 2025, the annual cash flow of the project is expected to stabilize at about 3 percent growth. The discount rate is 7 percent.
What is the terminal value of the project on January 1, 2026?
$108,150
Because cash flow is expected to grow at a stable rate of 3 percent after 2025, the cash of 2026, the first year of the stabilized period, is $4,200 × 1.03 = $4,326.
According to the Gordon Growth Model, Terminal Value = CF / (r − g) = $4,326 / (7% − 3%) = $108,150
A company is considering investing in a new project with infinite life. The estimated cash flows of the first three years of the project are shown as below:
Cash Flows 2021: $12,000
Cash Flows 2022: $15,000
Cash Flows 2023: $21,000
After 2023, the annual cash flow of the project is expected to stabilize at about 1 percent growth. The discount rate is 6 percent.
What is the present value of the project on January 1, 2021?
Present value of $1 for 1 year at 6 percent is 0.94340
Present value of $1 for 2 years at 6 percent is 0.89000
Present value of $1 for 3 years at 6 percent is 0.83962
$398,470
Because cash flow is expected to grow at a stable rate of 1 percent after 2023, the cash of 2024, the first period of stabilized period, is $21,000 × 1.01 = $21,210.
According to the Gordon Growth Model, Terminal Value = CF / (r − g) = $21,210 / (6% − 1%) = $424,200
Present Value on January 1, 2021 = ($12,000 × 0.94340) + ($15,000 × 0.89000) + ($21,000 × 0.83962) + ($424,200 × 0.83962) = $398,470
A project’s estimated net cash flows are shown as follows. The discount rate is 6 percent.
What is the Net Present Value of the project?
Present value of $1 for 7 years at 6 percent is 0.66506
Present value of an annuity of $1 for 6 years at 6 percent is 4.91732
Present value of an annuity of $1 for 7 years at 6 percent is 5.58238
$30,979
NPV = (−$40,000) + ($12,000 × 4.91732) + ($18,000 × 0.66506) = $30,979
Or
NPV = (−$40,000) + ($12,000 × 5.58238) + ($6,000 × 0.66506) = $30,979
Which of the following is INCORRECT in determining free cash flows?
A - Adjust net income for interest expense
B - Subtract capital expenditures
C - Subtract depreciation
D - Subtract change in working capital
C - Subtract depreciation
This is the correct answer! It is NOT true. You ADD BACK depreciation in determining free cash flows.
If a project’s IRR is higher than it’s WACC, the project will not be profitable. True or false?
False
What is free cash flow?
A - It is “free” money, which means it is available at a 0% interest rate.
B - It is the amount of cash that a business could be expected to generate from its normal operations.
C - Free Cash Flow is another name for Net Income.
D - It is the total amount of money being transferred into and out of a business.
B - It is the amount of cash that a business could be expected to generate from its normal operations.
Which of the following cash flows should be used in an NPV calculation to determine which project to pursue? (Select all that apply.)
A - The cash inflows expected as a result of the project
B - Recurring cash flows from ongoing current operations
C - Investment needed to be made by the company to undertake the project
D - Capital expenditures related to upkeep of existing equipment
A + C
A CFO of a start-up company is evaluating the timing of a significant capital expenditure. He was previously at a mature company that used a discount rate of 8% so he used the same rate at the start-up company.
Which of the following would be impacted if the discount rate were raised to reflect the risk of the start-up company?
A - IRR
B - Payback period
C - Return on investment
D - NPV
D - NPV
NPV is the only one of the answer choices that is impacted by the discount rate.
Which of the following statements is NOT true in relation to the Gordon Growth Model?
A - Terminal value is the present value of infinite cash flows expected in the future.
B - A higher discount rate results in a higher terminal value.
C - The Gordon Growth Model assumes that the growth rate will remain fixed.
D - A higher growth rate results in a higher terminal value.
B - A higher discount rate results in a higher terminal value.
This statement is not true. A higher discount rate results in a lower terminal value.
When projecting financial statements, which of the following accounts is difficult to forecast using the percent of sales method?
A - Accounts Receivable
B - Accounts Payable
C - Interest Expense
D - Cost of Sales
C - Interest Expense
Normally, Accounts Receivable, Accounts Payable, and Cost of Sales will trend in a direct relationship with sales. However, Interest Expense is more dependent upon the level of borrowings which does not necessarily track with sales.
A company is considering buying a diagnostic piece of equipment for $250,000. The machine will be depreciated on a straight-line basis for 10 years with a salvage value of $40,000. The company expects the machine to be able to generate after-tax revenues of $33,000 in each of the 10 years, and then it will sell the machine for $40,000 at the end of 10 years. The sum of the undiscounted cash flows is $370,000. The discount rate is 7%. The net present value is calculated to be $2,112.
Which of the following statements is true?
A - The company should not buy the equipment because the NPV is less than the annual revenues expected.
B - The company should not buy the equipment because the NPV is less than the initial cost of the equipment.
C - The company should buy the equipment because the sum of the undiscounted cash flows is greater than the initial cost of the equipment.
D - The company should buy the equipment because the NPV is positive.
D - The company should buy the equipment because the NPV is positive.
As long as the NPV is positive, even if it is a very small positive number, it means the company will earn a return greater than its discount rate, so it is a good investment.
Cybertrex, a manufacturing facility, rented a new piece of equipment on January 1st and agreed to pay an annual rental fee of $18,000 at the end of each of the next 10 years. The weighted average cost of capital of the company is 8%.
The present value of $1 for 10 years at 8% is 0.46319
The present value of an ordinary annuity of $1 for 10 years at 8% is 6.71008
What is the Present Value of the rental payments over 10 years?
$120,781
It is calculated by multiplying the annual payment by the present value of an annuity factor.
$18,000 * 6.71008 = $120,781
An automotive parts company that sells to automotive manufacturers is forecasting revenue as part of its internal budgeting and planning process. Which of the following is LEAST likely to be important in its forecasting assumptions?
A - Expected number of customers
B - Customer acquisition and retention rates
C - Profitability of customer orders
D - Level of long-term debt
D - Level of long-term debt
The level of long-term debt would not likely impact the revenue forecast.
On which financial statements would you be most likely to find information about capital expenditures related to the purchase of equipment during the past year?
A - Look at the ending balance of the PPE account in the balance sheet
B - Look for a large decrease in cash or large increase in accounts payable on the balance sheet
C - Look for a change in the depreciation expense on the income statement
D - Look at the investing section in the statement of cash flows
D - Look at the investing section in the statement of cash flows
The correct answer is to look at the investing section in the statement of cash flows. The other alternatives would only give partial, and possibly misleading, information about capital expenditures. The investing section of the statement of cash flows would directly show the cash spent on capital purchases.
Which of the following options is true in regards to financial forecasts?
A - Forecasts are calculated based on historical data figures so they are extremely accurate.
B - All cash flows will increase or decrease proportionately to forecasted sales numbers.
C - Forecasts are exclusively used internally by management on a company level for general budgeting purposes.
D - Odds are, forecasts will differ from actual results.
D - Odds are, forecasts will differ from actual results.
