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Flashcards in BEC 3 Financial modeling projections and analysis Deck (45)
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Relevant data concept

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


Cost behavior

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


Characteristics of relevant costs

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


Direct costs

- Relevant
- can identified with or traced to a given cost object


Prime costs

- Relevant
- Direct material or direct labor


Discretionary costs

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


Opportunity cost

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


Relevant costs

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


Alternative terms for relevant costs and revenues

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


Incremental costs

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


Avoidable costs and revenues

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.


Cash flow effects

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


Stages of cash flow

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


Stages of Cash flow

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


Asset sale

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


Calculation of aftertax cash flows

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.


Discounted Cash flow

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.


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

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


Rate of return desired for the project

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


Limitation of discounted cash flow-Simple constant growth assumption

- 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


Discounted cash flow is the basis for net present value methods

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


Net present value method

- 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


Calculation of net present value

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


Interpreting the NPV method

1. Positive result = make investment
2. Negative result = do not make investment


Interest rates adjustments for required return

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


Adjustments to rate

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


Differing rates

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


Discount rate applied to qualitatively desirable or non-optional investments

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)


Advantage and limitations of the Net Present Value Method

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


Capital rationing

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