chapter 8

Question 1

capital budget

Answer 1

lists the project and investments that a company plans to undertake during the coming year.

Question 2

capital budgeting

Answer 2

the process of determining the capital budget by analysing alternative projects and decide which ones to accept. the ultimate goal is to determine the effect of the decision on the firm’s cash flows and evaluate the NPV of these cash flows to assess the consequences of the decision for the firm’s value.

Question 3

incremental earnings

Answer 3

the incremental earnings of a project is the amount by which the firm’s earnings are expected to change as a result of the investment decision.

Question 4

straight-line depreciation

Answer 4

the simplest method of depreciation, in which the asset’s cost (less any expected salvage value) is divided equally over its estimated useful life.

Question 5

unlevered net income

Answer 5

net income not including any interest expenses associated with debt.

Question 6

marginal corporate tax rate

Answer 6

the tax rate it will pay on an incremental dollar of pre-tax income. this is the correct tax rate to use for the unlevered net income formula.

Question 7

opportunity cost

Answer 7

the opportunity cost of using a resource is the value it could have provided in its best alternative use. we include this as an incremental cost of the project.

Question 8

project externalities

Answer 8

indirect effects of the project that may increase or decrease the profits of other business activities of the firm.

Question 9

cannibalisation

Answer 9

when sales of a new product displace sales of an existing product.

Question 10

sunk cost

Answer 10

any unrecoverable cost for which the firm is already liable. sunk costs have been or will be paid regardless of the decision about whether or not to proceed with a project. eg. fixed overhead costs and R&D.

Question 11

overhead expenses

Answer 11

associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the corporation.

Question 12

free cash flow

Answer 12

the incremental effect of a project on the firm’s available cash, separate from any financing decisions. it is calculated on an unlevered basis (ie. it ignores financing items like interest expenses). free cash flows are cash flows available to financiers (debt and equity holders).

Question 13

depreciation

Answer 13

is not a cash expense that is paid by the firm. it is a method used for accounting and tax purposes to allocate the original purchase cost of the asset over its life. it is not a cash flow, so it is not included in the cash flow forecast.

Question 14

receivables

Answer 14

a firm’s receivables measure the credit the firm has received from its suppliers.

Question 15

trade credit

Answer 15

the difference between receivables and payable is the net amount of the firm’s capital that is consumed as a result of credit transactions.

Question 16

depreciation tax shield

Answer 16

the tax savings that result from the ability to deduct depreciation. consequently, depreciation expenses have a positive impact on free cash flow. it is tc * depreciation.

Question 17

Modified Accelerated Cost Recovery System/MACRS depreciation

Answer 17

categorises assets according to their recovery period and specifies a fraction of the purchase price the firm can depreciate each year.

Question 18

bonus depreciation

Answer 18

allows firms to deduct an additional portion of the purchase price when the asset is first placed into service. this is sometimes provided by the tax code.

Question 19

terminal or continuation value

Answer 19

represents the market value (as of the last forecast period) of the free cash flow from the project at all future dates. it is useful if a project has an erratic start but stable long-term cash flows.

Question 20

tax loss carry-forwards and carry-backs

Answer 20

allow corporations to take losses during a current year and offset them against gains in nearby years.

Question 21

NPV break-even level of input

Answer 21

the level for which the investment has an NPV of zero.

Question 22

EBIT break-even

Answer 22

the EBIT break-even for sales is the level of sales for which the project’s EBIT is zero.

Question 23

break-even analysis

Answer 23

in a break-even analysis the value at which the NPV of the project is zero is calculated for each parameter.

Question 24

sensitivity analysis

Answer 24

breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. it allows us to explore the effects of error in our NPV estimates for the project.

Question 25

scenario analysis

Answer 25

considers the effect on the NPV of changing multiple project parameters. because certain factors affect more than one parameter.

Question 26

capital expenditures (CapEx)

Answer 26

actual cash outflows when a fixed asset is purchased. it is included in calculating FCF.

Question 27

salvage value

Answer 27

some fixed assets can be sold at the end of the project. there are often tax effects involved.

Question 28

NPV break-even level of discount rate

Answer 28

is the Internal Rate of Return (IRR).

Question 29

incrementality principle

Answer 29

include only changes in profits, eg. changes in sales or costs, etc.

Question 30

opportunity cost of capital

Answer 30

the expected rate of return that can be earned on alternative investments with the same characteristics (risk, maturity). so, what we can earn with our investments compared to investing on the securities market.

Question 31

Weighted Average Cost of Capital (WACC)

Answer 31

the cost of capital if the average risk of the project is equal to the average risk of the firm. it is the weighted average of the cost of equity and the cost of debt and the market value of equity and debt are used as weights. it can only be used for projects where the risk is similar to the average risk of the firm.

Question 32

dividend discount model

Answer 32

discounting the dividends.

Question 33

sensitivity analysis

Answer 33

gives the different numbers that lead to the NPV break-even, eg. units sold number or sales price.

Question 34

NPV break-even levels

Answer 34

useful to determine how sensitive the NPV result is to change in the input factor. it also shows at what input level the decision changes.