BEC 3 Financial modeling projections and analysis

Question 1

Relevant data concept

Answer 1

revenues and costs related to financial decisions are only deemed to be relevant if they change as a result of selecting different alternative.

Question 2

Cost behavior

Answer 2

Fixed or variable costs may be relevant (more variable though)

Question 3

Characteristics of relevant costs

Answer 3

Often share similar characteristics like their specific traceability to cost objects that may change as a result of selecting different alternatives.

Question 4

Direct costs

Answer 4

• Relevant

- can identified with or traced to a given cost object

Question 5

Prime costs

Answer 5

• Relevant

- Direct material or direct labor

Question 6

Discretionary costs

Answer 6

• Relevant

- Costs arising from periodic budgeting decisions by management to spend in areas not directly related to manufacturing.

Question 7

Opportunity cost

Answer 7

• Relevant

- cost of foregoing the next best alternative when making a financial decision.

Question 8

Relevant costs

Answer 8

1. Direct
2. Prime
3. Discretionary
4. Opportunity

Question 9

Alternative terms for relevant costs and revenues

Answer 9

1. Incremental costs
2. Avoidable costs and revenues
   a. unavoidable costs
   b. sunk costs

Question 10

Incremental costs

Answer 10

differential costs or out of pocket costs are the additional costs incurred to produce an additional amount of the unit over the present output.

Question 11

Avoidable costs and revenues

Answer 11

result from choosing one course of action instead of another. As a result the firm avoids the cost or revenue associated with the other course of action:

a. Unavoidable costs - costs are the same not matter what you do
b. Sunk costs - unavoidable costs, because they were already spent and cant be recovered.

Question 12

Cash flow effects

Answer 12

1. Direct effect - the company pays and receives cash that is directly related to the capital investment. Immediate effect on the amount of cash available
2. Indirect effect - transactions either indirectly associated with a capital project or that represent non cash activity that produces cash benefits or obligations are termed indirect cash flow effects.
3. Net effect - the total of the direct and indirect effects of cash flows from a capital investment

Question 13

Stages of cash flow

Answer 13

1. Inception of the project
   a. Working capital requirements
   (1) Additional working capital requirements
   (2) Reduced working capital requirements
   b. Disposal of the replaced asset
   (1) asset abandonment
   (2) asset sale
2. Operations
3. Disposal of the project

Question 14

Stages of Cash flow

Answer 14

Step 1 Initial outflow
Invoice + Shipping + Installation (Outflow)
\+ Increase in Working Capital (Outflow)
- Cash proceeds on sale of old equipment (Inflow) 
= Net initial outflow
Step 2 Operations
Future annual cash inflow operations 
Pretax cash inflow x (1-Tax rate)
\+ Depreciation x Tax rate 
Step 3 Disposal
"One time" terminal year inflow (Disposal) 
Net proceeds from the sale of the asset (Net inflow)
- Severance pay (Outflow) 
\+ Tax savings (Inflow) 
\+ Decrease in Working capital (Inflow) 
= Terminal year net inflow

Question 15

Asset sale

Answer 15

Net proceeds on sale of old asset (net of tax):
Proceeds on sale (Inflow)
- Tax paid on gain (Outflow)
+ Tax saved on loss (Inflow)

Question 16

Calculation of aftertax cash flows

Answer 16

After-Tax cash flows - relevant to capital budgeting

(1) Estimate net cash inflows (cash inflows - cash outflows)
(2) Subtract noncash tax deductible expenses to arrive at taxable income
(3) Compute income taxes related to a project’s income or loss for each year of the project’s useful life
(4) Subtract tax exp from net cash inflows to arrive at after tax cash flows
(5) Multiply net cash inflows by (1-Tax rate) and add the tax shield associated with noncash exp. The sum of these two amounts will equal the after tax cash flows.
(6) The tax savings or exp related to a particular cash flow equals the amount of the expense or income times the firm’s marginal income tax rate.

Question 17

Discounted Cash flow

Answer 17

Discounted cash flow methods are techniques that use time value of money concepts to measure the present value of cash inflows and cash outflows expected from a project.

Question 18

Objectives and components of discounted cash flow as used in capital budgeting

Answer 18

a) relevant cash flows discounted to present value
b) evaluated by:
- the dollar amount of the initial investment,
- the dollar amount of future cash inflows outflows,
- the rate of return desired for the project

Question 19

Rate of return desired for the project

Answer 19

The rate used to discount future cash flows is set by management using several different approaches:

a) management may use a weighted average cost of capital method
b) management may simply assign a target for new projects to meet
c) management may recommended that the discount rate be related to the risk specific to the proposed project

Question 20

Limitation of discounted cash flow-Simple constant growth assumption

Answer 20

• Discounted cash flow methods are widely viewed as superior to methods that do not consider the time value of money,
• use a simple constant growth single interest rate assumption, which is often unrealistic, because over time, as management evaluates its alternatives, actual interest rates or risks may fluctuate

Question 21

Discounted cash flow is the basis for net present value methods

Answer 21

1. Calculate after tax cash flow = Annual net cash flow x (1-Tax rate)
2. Add depreciation benefit = Depreciation x tax rate
3. Multiply result by appropriate present value of an annuity
4. Subtract initial cash outflow
5. Net present value

Question 22

Net present value method

Answer 22

• focuses decision makers on the initial investment amount that is required to purchase in a capital asset that will yield returns in an amount in excess of a management designated hurdle rate
• requires managers to evaluate the dollar amount of return rather than either % of return or years to recover principal as a basis for screening investments

Question 23

Calculation of net present value

Answer 23

1. Estimate the cash flows
   a. Ignore depreciation
   b. Ignore method of funding
2. Discount the cash flows
3. Compare

Question 24

Interpreting the NPV method

Answer 24

1. Positive result = make investment

2. Negative result = do not make investment

Question 25

Interest rates adjustments for required return

Answer 25

Net present value analysis may incorporate many types of hurdle rates, such as the cost of capital, the discount rate of the opportunity cost, rates are determined by management

Question 26

Adjustments to rate

Answer 26

a. Risk - discount rates may be increased to further factor differences in risk into the analysis b. Inflation - rates may be raised to compensate for expected inflation

Question 27

Differing rates

Answer 27

may be used for different time periods using the NPV method.

Question 28

Discount rate applied to qualitatively desirable or non-optional investments

Answer 28

A project that meets qualitative management criteria for investment is purely subject to financing, rather than capital budgeting. The discount rate used for NPV evaluation should be the after-tax cost of borrowing (incremental borrowing rate)

Question 29

Advantage and limitations of the Net Present Value Method

Answer 29

1. Advantages - flexible and can be used when there is no constant rate of return required for each year of the project 2. Limitations - does not provide the true rate of return on the investment

Question 30

Capital rationing

Answer 30

1. Unlimited capital - all investments with a positive NPV should be pursued. 2. Limited capital: a. Importance b. Ranking and acceptance

Question 31

Profitability index

Answer 31

- the ratio of the PV of net future cash inflows to the PV of the net initial investments - "excess present value index" - "present value index" - ranking and selection of investment alternatives anticipate positive net present values for all successfully screened investments - profitability ratio should be over 1.0 Profitability index = PV of net future cash inflow / PV of net initial investment

Question 32

Measures cash flow return per dollar invested

Answer 32

1. Measures cash flow return per dollar invested - the higher the better 2. Application - projects with positive NPV are ranked in descending order by their profitability index

Question 33

Internal rate of return

Answer 33

- the expected rate of return of a project and is sometimes called the time-adjusted rate of return - determines the PV factor that yields an NPV equal to zero, - focuses the decision maker on the discount rate at which the PV of the cash inflows = PV of the cash outflows - focus is on %%%%

Question 34

Interpreting IRR for Investment decisions

Answer 34

1. Accept when IRR > Hurdle Rate | 2. Reject when IRR < Hurdle rate

Question 35

Limitations of IRR

Answer 35

1. Unreasonable reinvestment assumption - If internal rates of return are unrealistically high or unrealistically low, assumed returns on reinvested cash flows based on IRR rates could lead to inappropriate conclusions. 2. Inflexible cash flow assumptions - the timing of the amount of cash flows used to determine IRR can be misleading when compared to the NPV method. The IRR method is less reliable than the NPV method when there are several alternating periods of net cash inflows and net cash outflows or the amounts of the cash flows differ significantly. 3. Evaluates Alternatives Based Entirely on Interest rates

Question 36

Payback period method

Answer 36

- time required for the net after tax cash inflows to recover the initial investment in a project - liquidity - project's liquidity and the time during which return of principal is at risk - risk - the greater the risk of the investment, the shorter the payback that is expected by the company

Question 37

The formula for calculating the payback period

Answer 37

Payback period = Net initial investment / Increase in annual net after tax cash flow

Question 38

Cash flow assumptions | Uniform cash inflows

Answer 38

The net cash inflows are assumed to be constant for each period during the life of the project. The payback period is computed at the point of initial investment using after tax cash flows. a. Project evaluation - the net cash inflow would be the net cash receipts associated with the project b. Asset evaluation - the net annual cash inflow will be the savings generated by use of the new equipment c. Depreciation tax shield -add it (depreciation exp is not considered, unless it is a tax shield)

Question 39

Cash flow assumptions | Non-uniform cash flows

Answer 39

The standard payback formula shown above applies to uniform annual cash inflows. If cash flows are not uniform, a cumulative approach to determining the payback period is used. a. Accumulate until equal to initial net investment - the net after tax cash inflow per year is used as the basis for evaluation of projects with nonuniform cash flows. These net after tax cash inflows are accumulated until the time that they equal the initial investment. b. End of the payback period - the point at which the cumulative net after tax inflows equal the initial net investment is the end of the payback period.

Question 40

Advantages of payback

Answer 40

1. Easy to use and understand | 2. Emphasis on liquidity

Question 41

Limitations of payback

Answer 41

1. the time value of money is ignored 2. project cash flows occurring after the initial investment is recovered are not considered 3. reinvestment of cash flows is not considered 4. total project profitability is neglected

Question 42

Discounted payback method

Answer 42

- computes the payback period using expected cash flows that are discounted by the project's cost of capital - evaluates how quickly new ideas are converted into profitable ideas

Question 43

Discounted payback method

Answer 43

- computes the payback period using expected cash flows that are discounted by the project's cost of capital

Question 44

Objective of discounted payback method

Answer 44

1. Focus on liquidity and profit 2. Evaluation term 3. Common project using discounted payback

Question 45

Advantages and limitations of discounted payback method

Answer 45

1. Advantages - incorporates the time value money | 2. Limitation - focuses on how quickly the investment is recouped than overall profitability