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Flashcards in Chapter 14 : general guidelines Deck (5)
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1

Your boss is puzzled by the finance courses in the MBA program. he has learned that "Cash flow is king" but notices that the capital budgeting problems spend a lot of time and effort dealing with depreciation and CCA but not with interest expenses. he knows that depreciation and CCA are non-cash expenses, and he knows that interest is definitely a cash expense. he would like an explanation of why he needs to bother with depreciation and CCA but not with interest expenses

to evaluate an investment we have to begin by determining the cash flows associated with the project. depreciation and CCA are non-cash expenses that can have cash flow consequences.
I) depreciation: to determine cash flow we can start with net income and then add back the noncash expenses, such as depreciation, to obtain cash flow
ii CCA: this is a little different than other non-cash expenses because while it is a non-cash expense it has a direct effect on cash flows through its effect on taxes paid

2

Firms A and B are competition for a project. the potential client has provided the following information on a hypothetical project:
initial cost is $50,000
building renovation is $600,000
and the building cannot be rented due to the project (Currently the building is vacant)
firm B had made the following statement to the board of directors:
we have conducted an extensive analysis of the project and have concluded that your decision should consider the initial cost 0f $500,000 only. the $600,000 spent on renovation does not affect future cash flow; therefore we can ignore it. the potential rental revenues should be ignored also, as the building is currently empty and therefore is not a cost of this project.

Firm b is 1/2 right . to evaluate any project we have to ignore sunk costs (the $600,00 is sunk cost) and take into consideration opportunity costs (ie projects foregone) in determining the incremental costs. therefore, the analysis should take into account the initial costs and foregone rents but not the $600,00 sunk renovation costs

3

An investor has observed that Bath company, a shareholder wealth-maximizing company, has just made an investment that appears to have a negative NPV. the investor is very puzzled about why a company would undertake a negative NPV project. assume that the NPV of the cash flows is in fact negative, and the project is actually shareholder wealth maximizing. what aspect of th project tis the investor not considering

the investor has not taken into account the impact of financial distress on the firm's decision making. if Bath is in financial distress, then accepting a negative NPV project may be shareholder wealth maximizing. in this case, the shareholders care about the expected upside (the part of the gains from the project obtained by shareholders) but not about the downside (the shareholders have nothing to lose; the firm is in trouble and they probably would have obtained nothing anyways). consequently, if the project has good upside potential, it may be shareholder wealth maximizing even though the NPV is negative.

4

Jensen's Jice Bar is considering purchasing a new blender. indicate which of the following staetments is relevant consideration in the new blender decision.

a. last year, Jansen's spent $500 on a new blender
b. customers would prefer to have their juice made in the new blender and won't buy juice produced in the old one
c. the manager of the juice bar just got a raise
d. the juice bar's tax rate 29%
e. the monthly rent is $500
f. if Jensen's buys a blender, there will be no space for a coffee maker
g. the new blender is blue, and blue is your fav. colour
h. Jansen's juice bar spent $10,000 in renovations last year

a. not relevant (sunk cost)
b. relevant (project interdependencies)
c. Not relevant (sunk cost)
d. Relevant (to determine after-tax cash flows)
e. not relevant (need to consider incremental cash flows; this is not changed by the new blender)
f. Relevant (Project interdependencies, incremental cash flow - foregone coffee revenues)
g. not relevant (not related to cash flow or discount rate)
h. Not relevant (sunk cost)

5

Summarize all cash flows that cannot be used in the capital budgeting process and explain the reasons

Sunk costs: cannot be included because we are considering future cash flows while sunk costs have occurred in the past and cannot be recovered
Interest and dividend payments; also should be excluded as they have already been included in the discount rate
Externalities: should be excluded since they are side effects that often result from an investment that may benefit or even harm unrelated third parties. besides, we should ignore intangible considerations that cannot be measured