HBX- Accounting 7

Question 1

Pro-Forma Financial Statements

Answer 1

Financial Statements forecasted for future periods. May also be referred to as a financial forecast or financial projection. In this course, we use pro-formas as a depiction of what the financial statements for the business will look like over a certain period of time, if the assumptions made when preparing them hold true.

Question 2

Metropolis had net sales of ₹120 million in 2003 related to pathology services.
They expect sales of pathology services to grow by 75% in 2004.
Metropolis also plans to introduce a new service, Home Healthcare Blood Draws, which will generate sales of ₹10 million in 2004.
What will be the forecasted net sales for 2004?

₹120

₹10

₹220

₹75

Answer 2

₹220

Pathology revenue is expected to increase by 75% and Home Healthcare Blood Draws revenue is expected to add ₹10 million. In order to calculate, multiply the prior year’s revenue by 175% and add ₹10 million.

Calculation: (120.0 * 1.75) +10 = 220.0

Question 3

Metropolis had net sales of ₹120 million in 2003 related to pathology services.
They expect sales of pathology services to grow by 75% in 2004.

Metropolis also plans to introduce a new service, Home Healthcare Blood Draws, which will generate sales of ₹10 million in 2004.

Metropolis expects sales of pathology services to grow by 75% in 2005.
Home Healthcare Blood Draws will generate sales of ₹20 million in 2005.
What will be the forecasted net sales for 2005?

HINT: You must compound the 2003 sales (₹120 million) twice rather than simply multiplying the 2004 revenue by 175% because the 2004 revenue includes ₹10 million of Home Healthcare Blood Draws revenue.

₹20

₹220

₹75

₹387.5

Answer 3

387.5

Pathology revenue is expected to increase by 75% and Home Healthcare Blood Draws revenue is expected to add ₹20 million. In order to calculate, multiply the 2003 revenue by 175% compounded twice and add ₹20 million.

Calculation: (120.0 * 1.75 * 1.75) + 20 = 387.5

Question 4

The primary costs that make up the cost of sales for Metropolis are employee costs, chemical costs, and supplies costs. Employee costs are forecast to be 20% of revenue, chemical costs are forecast to be 20% of revenue, and supplies costs are forecast to be 5% of revenue, for a total of 45%. With forecasted sales revenue of ₹220 for 2004, what will be the forecasted cost of sales for 2004?

₹220

₹45

₹99

₹20

Answer 4

99
Cost of sales is forecast to be 45% of net sales (sum of employee cost, 20% + chemical cost, 20% + supplies cost, 5%). In order to calculate, multiply 2004 sales by 45%.
Calculation: (220.0 * 0.45) = 99.0

Question 5

Variable costs

Answer 5

Variable costs are costs that rise and fall with revenue or activity. An example could be the cost of flour at a bakery which would tend to change in proportion with sales. It stands to reason that many current asset accounts, such as accounts receivable and inventory, and current liability accounts, such as accounts payable, would tend to increase or decrease proportionately with revenue.

Question 6

What are the steps in creating a full Pro-Forma Statement?

Answer 6

1. Determine the expected sales
2. Look for trends and relationships among the various components of costs to forecast the cost of Sales & Operating Costs & Inventory
3. Calculate Accounts Receivable . (Normally they’ll have a percentage for this. For example, 70% of sales is for credit purchases with a turn over of 6. This means to multiply revenue by .**7 and then divide by 6)
4. Forcast Salaries and Wages Payable. This depends on the number of staff and the monetary value of the payroll as well as other factors such how often the employees are paid (weekly, bi-weekly, monthly, etc), whether employees are paid in arrears (often paid a few days after the end of the pay period) and how close the end of the pay period is to the end of the accounting period.
   For the purposes of this forecast/module example, assume that the Salaries and Wages Payable will change in proportion to Revenue. Since, Salaries and Wages Payable will change in proportion to revenue, you will need to multiply the prior year’s Salary and Wages Payable by the change in revenue from prior year to current year.
   For example, if last years revenue was 120 and this year’s revenue was 220, you would multiply last years salaries & wages payable by 220/120.
5. Alter P, E, & E - (Examples for altering listed below)
   
   1. new equipment could be purchased to replace older equipment.
   2. Second, as businesses are acquired it is anticipated that a portion of the acquisition cost is assigned to the value of the equipment of the acquired business.
   3. initial investments for new ventures/opening new locations.
   4. Depreciation- (rememer land doesn’t depreciate- also confirm what type of depreciation)
6. Borrowings & Interest - This causes a circulatory problem.
   The circularity problem in forecasting interest and borrowings occurs when a company is relying on borrowings to finance the business activities. However, some companies have no borrowings and, hence, no interest expense. Some other companies do have some amount of borrowings but they are not relying on those borrowings to finance their operations.
   1. Figure out Loans (hopefully, they are predictable like mortgages and just need rounding!) and add it to current portion of debts
   2. If the above is a payment on long-term debt, subtract that amount from long-term debt to receive new long-term debt amount.
   3. Edit Interest Expenses (check to see if it’s for the beginning or end of the year)
7. Income Tax Expense -
   Income Tax Expenses = Tax Rate x Income Before Taxes
8. Forcast Common Stock-
   Common stock reflects the amount of funding raised by issuing shares of stock to individuals that will hold a stake in the company. We would generally expect common stock to stay the same from year to year, unless the business is planning on issuing more stock or buying back its own outstanding shares.
9. Retained Earnings
   How to Forcast Retained Earnings = Previous Retained Earnings + Current Year Net Income (Excluding the amounts to be distributed to shareholders)
10. Solve for Cash or Borrowings!
    We simply subtract the balances of the asset accounts that have been forecast from the total liabilities and equity in the forecast to arrive at the forecast for cash.
    CASH = EQUITY + LIABILITIES - (Sum of all ASSETS that aren’t CASH)
    1. Note that in forecasts for businesses that finance their operations with borrowings:
       
       1. you will solve for borrowings as the plug and
    2. in forecasts for businesses that do not finance their operations with borrowings
       
       1. you will solve for another variable, such as cash, as the plug. In the case of a startup, it may be most appropriate to use equity as a plug, so the company can determine how much equity financing they will need to fund their operations.

Question 7

For Metropolis, sales & marketing expenses are expected to be 12% of revenue. With forecasted sales revenue of ₹220 for 2004, what will be the forecasted sales & marketing expenses for 2004? ​​

₹10.2

₹12.1

₹22.2

₹26.4

Answer 7

₹26.4​​

Sales & marketing expenses are expected to be 12% of net sales. In order to calculate, multiply 2004 sales by 12%.

Calculation: (220.0 * 0.12) = 26.4

Question 8

How to decide the level of detail for a pro-forma statement?

Answer 8

The level of detail and attention given to forecasting individual expense items will depend on the purpose of the forecast.

• If the forecaster is only interested in high-level general trends, then assumptions can be broad and details sparse.
• However, if the forecast will be used to decide whether to acquire a business, the forecast should be thorough and the details plentiful.

Question 9

How to get the #’s in blue…

Answer 9

Remember: you should use formulas and linked cells whenever possible when using spreadsheets. The answers below reflect the use of the formulas shown.

2004: Administrative expenses are expected to be 8% of sales. In order to calculate, multiply this year’s sales by 8%.

Calculation: (220.0 * 0.08) = 17.6

Formula: =D6*0.08

2005: Administrative expenses are expected to be 8% of sales. In order to calculate, multiply this year’s sales by 8%.

Calculation: (387.5 * 0.08) = 31.0

Formula: =E6*0.08

2006: Administrative expenses are expected to be 8% of sales. In order to calculate, multiply this year’s sales by 8%.

Calculation: (611.3 * 0.08) = 48.9

Formula: =F6*0.08

Question 10

Turnover

Answer 10

is an accounting term that calculates how quickly a business collects cash from accounts receivable or how fast the company sells its inventory. In the investment industry, turnover is defined as the percentage of a portfolio that is sold in a particular month or year.

Question 11

Answer 11

2004: 60% of sales are on credit and accounts receivable are expected to turn over 6 times per year. In order to calculate, multiply this year’s sales by 60% to get sales on credit, and divide by the turnover of 6 to get the balance of accounts receivable at the end of the year.

Calculation: (220.0 * 0.6) / 6 = 22.0

Formula: =(D6*0.6)/6

2005: 60% of sales are on credit and accounts receivable are expected to turn over 6 times per year. In order to calculate, multiply this year’s sales by 60% to get sales on credit, and divide by the turnover of 6 to get the balance of accounts receivable at the end of the year.

Calculation: (387.5 * 0.6) / 6 = 38.8

Formula: =(E6*0.6)/6

2006: 60% of sales are on credit and accounts receivable are expected to turn over 6 times per year. In order to calculate, multiply this year’s sales by 60% to get sales on credit, and divide by the turnover of 6 to get the balance of accounts receivable at the end of the year.

Calculation: (611.3 * 0.6) / 6 = 61.1

Formula: =(F6*0.6)/6

Question 12

Answer 12

2004: Days Purchases Outstanding is expected to remain constant at 40.6 days. Recall that Days Purchases Outstanding is calculated as (Accounts Payable)/(COGS/365). In order to calculate, we can rearrange this formula to solve for Accounts Payable by multiplying the Days Purchases Outstanding by (COGS/365).

Calculation: 40.6 * (99.0 / 365) = 11.0

Formula: =40.6*(D7/365)

2005: Days Purchases Outstanding is expected to remain constant at 40.6 days. Recall that Days Purchases Outstanding is calculated as (Accounts Payable)/(COGS/365). We can rearrange this formula to solve for Accounts Payable by multiplying the Days Purchases Outstanding by (COGS/365).

Calculation: 40.6 * (174.4 / 365) = 19.4

Formula: =40.6*(E7/365)

2006: Days Purchases Outstanding is expected to remain constant at 40.6 days. Recall that Days Purchases Outstanding is calculated as (Accounts Payable)/(COGS/365). We can rearrange this formula to solve for Accounts Payable by multiplying the Days Purchases Outstanding by (COGS/365).

Calculation: 40.6 * (275.1 / 365) = 30.6

Formula: =40.6*(F7/365)

Question 13

Answer 13

Remember: you should use formulas and linked cells whenever possible when using spreadsheets. The answers below reflect the use of the formulas shown.

2004: Salaries and Wages Payable are expected to change proportionally to revenue. In order to calculate, multiply the prior year’s Salary and Wages Payable by the ratio of this year’s sales to the prior year’s sales.

Calculation: 0.2 * (220.0 / 120.0) = 0.4

Formula: =B34*(D6/B6)

2005: Salaries and Wages Payable are expected to change proportionally to revenue. In order to calculate, multiply the prior year’s Salary and Wages Payable by the ratio of this year’s sales to the prior year’s sales.

Calculation: 0.4 * (387.5 / 220.0) = 0.6

Formula: =D34*(E6/D6)

2006: Salaries and Wages Payable are expected to change proportionally to revenue. In order to calculate, multiply the prior year’s Salary and Wages Payable by the ratio of this year’s sales to the prior year’s sales.

Calculation: 0.6 * (611.3 / 387.5) = 1.0

Formula: =E34*(F6/E6)

Question 14

Answer 14

2004: PP&E is comprised of three separate components: land, buildings, and equipment. Land is not depreciated. Depreciation expense for equipment is given, ₹16.4 million. Buildings with an original cost of ₹40 million are being depreciated straight-line over 40 years, so we can simply divide ₹40 million by 40 years to find the depreciation expense on the buildings.

Calculation: = 16.4 + (40 / 40) = 17.4

2005: PP&E is comprised of three separate components: land, buildings, and equipment. Land is not depreciated. Depreciation expense for equipment is given ₹19.1 million, Buildings with an original cost of ₹40 million are being depreciated straight-line over 40 years, so we can simply divide ₹40 million by 40 years to find the depreciation expense on the buildings.

Calculation: = 19.1 + (40 / 40) = 20.1

2006: PP&E is comprised of three separate components: land, buildings, and equipment. Land is not depreciated. Depreciation expense for equipment is given, ₹24.5 million. Buildings with an original cost of ₹40 million are being depreciated straight-line over 40 years, so we can simply divide ₹40 million by 40 years to find the depreciation expense on the buildings.

Calculation: = 24.5 + (40 / 40) = 25.5

Question 15

Answer 15

Remember: you should use formulas and linked cells whenever possible when using spreadsheets. The answers below reflect the use of the formulas shown.

2004: Accumulated depreciation is calculated by adding this year’s depreciation expense to the prior year’s accumulated depreciation.

Calculation: (-91.2 - 17.4) = -108.6

Formula: =B29-D11

2005: Accumulated depreciation is calculated by adding this year’s depreciation expense to the prior year’s accumulated depreciation.

Calculation: (-108.6 - 20.1) = -128.6 (Note: due to the use of formulas and rounding, the answer here is -128.6)

Formula: =D29-E11

2006: Accumulated depreciation is calculated by adding this year’s depreciation expense to the prior year’s accumulated depreciation.

Calculation: (-128.6 - 25.5) = -154.1

Formula: =E29-F11

Question 16

Answer 16

2004: The current portion of long term debt is forecast to be ₹1.03 million (rounded to 1.0). Recall that at December 31, 2004, the current portion of long term debt is equal to the amount expected to be paid in the coming year, 2005.
2005: The current portion of long term debt is forecast to be ₹1.08 million (rounded to 1.1). Recall that at December 31, 2005, the current portion of long term debt is equal to the amount expected to be paid in the coming year, 2006.
2006: The current portion of long term debt is forecast to be ₹1.135 million (rounded to 1.1). Recall that at December 31, 2006, the current portion of long term debt is equal to the amount expected to be paid in the coming year, 2007.

Question 17

Answer 17

2004: Since no additional long term debt is expected to be acquired, long term debt is calculated simply as the prior year’s long term debt less this year’s current portion of long term debt.

Calculation: 31.4 - 1.0 = 30.4

Formula: =B37-D35

2005: Since no additional long term debt is expected to be acquired, long term debt is calculated simply as the prior year’s long term debt less this year’s current portion of long term debt.

Calculation: 30.4 - 1.1 = 29.3

Formula: =D37-E35

2006: Since no additional long term debt is expected to be acquired, long term debt is calculated simply as the prior year’s long term debt less this year’s current portion of long term debt.

Calculation: 29.3 - 1.1 = 28.2

Formula: =E37-F35

Question 18

Answer 18

2004: Interest expense is forecast to be 5% of the total long term debt balance at the beginning of the year. In order to calculate, add the prior year’s current portion and non-current portion of long term debt, and multiply by 5%.

Calculation: (1.0 + 31.4) * 0.05 = 1.6

Formula: =(B35+B37)*0.05

2005: Interest expense is forecast to be 5% of the total long term debt balance at the beginning of the year. In order to calculate, add the prior year’s current portion and non-current portion of long term debt, and multiply by 5%.

Calculation: (1.0 + 30.4) * 0.05 = 1.6

Formula: =(D35+D37)*0.05

2006: Interest expense is forecast to be 5% of the total long term debt balance at the beginning of the year. In order to calculate, add the prior year’s current portion and non-current portion of long term debt, and multiply by 5%.

Calculation: (1.1 + 29.3) * 0.05 = 1.5

Formula: =(E35+E37)*0.05

Question 19

What is the circularity issue with borrowings and interest?

Answer 19

Borrowings are used to determine the interest expense,
which impacts net income and retained earnings.
But retained earnings are used to calculate borrowings.
To resolve the circularity,
you will have to go through a couple of iterations
to get the balance sheet equation to balance.

Question 20

COMMON STOCK

Answer 20

Common stock reflects the amount of funding raised by issuing shares of stock to individuals that will hold a stake in the company. We would generally expect common stock to stay the same from year to year, unless the business is planning on issuing more stock or buying back its own outstanding shares. In our example below, we’ll assume it is going to stay constant from one year to the next.

Question 21

Define Retained Earnings and how to forcast them.

Answer 21

Retained earnings reflects the earnings that have been retained in the business to finance growth or future operations. For any given year, we can forecast retained earnings by adding the amount of prior year retained earnings plus current year net income, excluding amounts to be distributed to shareholders.

How to Forcast Retained Earnings = Previous Retained Earnings + Current Year Net Income (Excluding the amounts to be distributed to shareholders)

Question 22

Answer 22

Question 23

Answer 23

Question 24

How To Solve for a Cash Forecast!

Answer 24

Is a business doesn’t use borrowings you’ll need to solve for cash?

• We simply subtract the balances of the asset accounts that have been forecast from the total liabilities and equity in the forecast to arrive at the forecast for cash.
  CASH = EQUITY + LIABILITIES - (Sum of all ASSETS that aren’t CASH)
• Note that in forecasts for businesses that finance their operations with borrowings:
  
  • you will solve for borrowings as the plug and
• in forecasts for businesses that do not finance their operations with borrowings
  
  • you will solve for another variable, such as cash, as the plug. In the case of a startup, it may be most appropriate to use equity as a plug, so the company can determine how much equity financing they will need to fund their operations.

Question 25

Answer 25

Question 26

Free Cash Flows. Define & List Equation

Answer 26

As with most financial analysis tools, free cash flows can be calculated in different ways depending on the purpose, the audience and the information available. In some cases, free cash flows are defined as **operating cash flow - capital expenditures.** Regardless of the precise methodology, free cash flows are intended to show the company’s normal ability to generate cash. In this course, we will use one of the most common methods to calculate free cash flows using the equation attached below. 1. The first step in calculating free cash flows is to eliminate the impact of how the business or investment is financed. Free Cash Flows are normally calculated so they can be compared to some other alternative use of funds. In order to put the alternatives on a comparable basis they need to be financed on a comparable basis. The easiest way to do this is to assume that they are financed entirely by equity. 2. Calculate: 1. **EBIT (by** adding back the interest expense and income taxes expense lines to the net income) 2. Then **EBIAT (**by multiplying **1- the tax rate \* EBIT)** 3. Create a new row on the spreadsheet for **depreciation** 4. Create a new row on the spreadsheet for **Capital** **Expeditures** 5. Calculate Change in **Networking Capital** by: * *CHANGE IN** **NET WORKING** **CAPITAL =** * *NET WORKING** **CAPITAL FOR CURRENT YEAR** *(which is* *NET WORKING* *CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES)* - **NWC PREVIOUS YEAR** *(which is* *NET WORKING* *CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES)*

Question 27

**How to** **Calculate** **EBIAT**

Answer 27

**How to** **Calcuate****: EBIAT, Earnings Before Interest After Taxes: we first calculate Earnings Before Interest and Taxes or EBIT for short. The information for calculating EBIT comes from the income statement.** * Starting with the bottom line, net income, we **_add back the interest expense and income taxes expense lines_**. The result is EBIT. Once we have EBIT, we can easily calculate EBIAT. * To calculate EBIAT **_we multiply EBIT by 1 minus the tax rate_**. So at this stage, we have merely taken away the impact of interest from the income statement. We have re-applied the tax rate to the EBIT in arriving at EBIAT.

Question 28

Which of the following statements are true? Select all that apply. * EBIT equals EBIAT if there is no interest expense. * EBIAT eliminates the impact of interest and taxes from the net income. * EBIAT re-applies the tax rate to a pretax amount that excludes the cost of interest. * The term Free Cash Flow means that no outside entity has any claim on these funds.

Answer 28

* **EBIAT re-applies the tax rate to a pretax amount that excludes the cost of interest.** * This is the correct answer! This statement is true.

Question 29

Suppose a company has a piece of machinery and the company spends money on maintenance to extend the useful life of the machine. The company is considering the decision of whether to capitalize the cost of maintenance to increase the asset's book value, or to record the cost of maintenance immediately as an expense. Does this decision affect free cash flow? Yes or No Why or Why not?

Answer 29

Yes - because EBIT will be affected by depreciation expense, which will be different depending on the decision. NOT "Yes - because the company is spending cash on the maintenance, which is a direct cash flow." The decision to capitalize (Fund?) versus expense does not change the effect of the cash spent on maintenance.

Question 30

Answer 30

Question 31

What does it mean to have account cash inflow and outflow for capital expenditures?

Answer 31

This refers to when cash is actually paid for property and equipment regardless of when the depreciation is recognized on the asset.

Question 32

Answer 32

Question 33

What is Net Working Capital & the Change in Net Working Capital and how do you calculate them?

Answer 33

Net working capital refers to the business having cash tied up in operations. As the business grows, it will typically need more cash to fund day to day operations. For example, as a business increases its sales, and services more customers, it will often need to increase the amount of inventory that it carries. **This is cash that will be dedicated to the business and won’t be available for other purposes.** *We measure net working capital…..* * *NET WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES** * \*note _CURRENT_ not non-current* *To calculate the change in net working capital, which we need for our calculation of free cash flows……* **CHANGE IN** **NET WORKING** **CAPITAL = NET WORKING CAPITAL FOR CURRENT YEAR - NWC PREVIOUS YEAR** \*When calculating the Change in NWC - enter BOTH formulas \*Current Year - PREVIOUS year - you HAVE to enter descriptions for BOTH For the exercise in the module.... "working capital only includes accounts receivable, inventory, accounts payable and salaries/wages payable. Please exclude cash."... don't know if this will be the same for the test

Question 34

Answer 34

Current assets (excluding cash) less current liabilities equals Net Working Capital. In this case, currents assets total $1,700 (accounts receivable and inventory) and current liabilities total $1,200. The difference, NWC, is $500.

Question 35

Answer 35

Change in Net Working Capital is calculated as the current year's net of current assets (excluding cash) and current liabilities less the prior year's net of current assets and current liabilities. The Net Working Capital for 2007 was $1,400. The Net Working Capital for 2006 was $1,325. **The difference, the change in NWC, is 75.**

Question 36

Answer 36

Question 37

Answer 37

Question 38

Why is it so important to calculate free cash flows?

Answer 38

1. First, **opportunity cost.** A dollar received today can be invested in other projects that will make more money.If the dollar isn't received until a later date, the potential return on investment is forfeited. \<- if $ was invested in a project, stock or bond 2. Next, most economies experience **inflation,** meaning that the purchasing power of its currency is diminishing over time. What a dollar can buy today is much less than what it could, say, 50 years ago. 3. Finally, **the dollar received in the future is less certain.** The more time between now and when the dollar will be received, the more likely it is that something will happen that will result in the dollar not being transferred. For example, the person who owes you the dollar could go bankrupt. The result is more value being associated with the dollar being received sooner.

Question 39

HOW TO CALCULATE PRESENT VALUE?

Answer 39

HOW TO CALCULATE PRESENT VALUE! =PV(rate,nper,pmt) * Rate is the interest rate (also known as discount rate) for the period. * Nper is the number of payment periods for the given cash flow. * Pmt is the payment, or cash flow, to be discounted. Note that the PV formula assumes that the payments are equal over the total number of periods, meaning it is essentially a formula used to calculate the present value of an annuity. **_It is calculated by multiplying the annual payment by the present value of an annuity factor._** ANNUAL PAYMENT \* PRESENT VALUE OF AN ANNUITY

Question 40

What is the discount rate?

Answer 40

Discount Rate A percentage rate determined by a company used to calculate the present value for a stream of future cash flows. The discount rate is somewhat subjective and is meant to take all of the factors that impact the time value of money into account, e.g. opportunity cost, inflation, and risk.

Question 41

Answer 41

The correct answer is -$105,925. The correct answer formula is: =PV(E4,E5,E6) Where # Periods (E5) is 15, and Pmt Amount (E6) is 12,000. Notice that the PV formula makes the answer negative. This is because it represents the amount you would be willing to pay today to receive the given cash flows. You would be willing to pay this amount because it is equivalent to the amount you will receive, so the net amount you pay and receive will be zero. So, if your discount rate is 7.5%, you would be willing to pay $105,925 for equipment that would provide this stream of rental income over the next 15 years.

Question 42

What is The Gordon Growth Model?

Answer 42

It is not practical, and in some cases not even possible, to determine the cash flows for each year when the project can last a long time or even indefinitely. Fortunately, there are alternative ways to estimate the value of a seemingly endless cash flow. One example of a way to estimate the value of a seemingly endless stream of cash flows is the Gordon Growth Model. * This model makes a major assumption that growth will remain steady indefinitely. As a result, this model should only be used once the cash flows are expected to stabilize. In periods of high growth or expected fluctuations, businesses should project the cash flows on a yearly basis. * It is worth noticing, that since this equation gives us the present value of the cash flows as of the end of our forecast, we still need to discount the value back to the beginning of our forecast using the present value technique we introduced in the previous concept.

Question 43

A company is considering investing in a new project with an infinite life. The estimated cash flows of the first three years of the project are shown in the attached photo. After 2016, annual cash flow of the project is expected to stabilize at about 2% growth. The discount rate is 5%. 1. What is the Terminal Value of the project on 1/1/2017? 2. What is the Present Value of the project on 1/1/2014? * The present value of $1 for 1 year at 5% is 0.95238 * The present value of $1 for 2 years at 5% is 0.90703 * The present value of $1 for 3 years at 5% is 0.86384

Answer 43

**Solution to #1:** Because cash flow is expected to grow at a stable rate of 2% after 2016, we can calculate the cash flow of 2017, the first period of stabilized period, as $2,000 \* 1.02 = $2,040. According to the Gordon Growth Model: Terminal Value = CF / (r - g) = $2,040 / (5% - 2%) = $68,000 So the terminal value of the project on 1/1/17 is $68,000. **Solution:** We have already calculated that the terminal value is $68,000. Now, we just need to find the present value of all cash flows, including the terminal value. ($1,000 \* 0.95238) + ($1,500 \* 0.90703) + ($2,000 \* 0.86384) + ($68,000 \* 0.86384) = $62,780 So the present value of the project on 1/1/14 is $62,780.

Question 44

Which of the following statements is NOT true regarding the calculation of Terminal Value under the Gordon Growth model? * Terminal Value is the present value of cash flows expected in the indefinite future. * A major assumption of Terminal Value model is that the growth rate will remain fixed. * The higher the discount rate, the greater the Terminal Value is. * The higher the growth rate, the greater the Terminal Value is.

Answer 44

* **The higher the discount rate, the greater the Terminal Value is.** * This is the correct answer! This statement is NOT true. Gordon Growth Model: P = CF / (r - g) P - Present value of the future cash flows CF - Cash flow expected in the last year projected r - Discount rate g - Expected growth rate According to the Gordon Growth Model, the higher the discount rate, the smaller the Terminal Value is.

Question 45

Answer 45

The correct answer is: $108,150 Because cash flow is expected to grow at a stable rate of 3% after 2018, the cash of 2019, the first period of 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

Question 46

Answer 46

The correct answer is $398,470. Because cash flow is expected to grow at a stable rate of 1% after 2016, the cash of 2017, 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 1/1/2014 = ($12,000 \* 0.94340) + ($15,000 \* 0.89000) + ($21,000 \* 0.83962) + ($424,200 \* 0.83962) = $398,470

Question 47

Net Present Value (NPV)

Answer 47

Net Present Value (NPV) The net present value is a calculation of the present values of all the cash inflows and outflows of a project or investment. The result is a single number that gives a good indication of what a business or a particular investment is worth today. How to Calculate Net Present Value: Using PV Tables First, let’s learn how to calculate net present value using present value tables, you simply need to find the present values of each cash flow stream and then add them all together, including any initial cash flows, to get the net present value. **How to Calculate NPV (Net Present Value): Using a Spreadsheet =NPV(rate,value1,value2, …)** * Rate is the interest rate (also known as discount rate) for the period. * Value1, value2, … are equally spaced cash flows that occur at the end of each period. \*\*\*There is one important thing to note about using the NPV formula. The formula itself does not include any cash flow at time 0 (today). Instead, the formula takes into account all future cash flows, and nets them back to the present value today, so if there are any cash flows at time 0 (today), those must be added or subtracted manually.

Question 48

Suppose you are considering buying a machine that costs $7,000. Three years from now, it is expected to require an upgrade that will cost $2,500. It will generate net cash flows of $1,500 for the next 8 years. If your discount rate is 8%, what is the net present value of this investment? * The present value of $1 for 3 years at 8% is 0.79383 * The present value an ordinary annuity of $1 for 8 years at 8% is 5.74664

Answer 48

Solution: To solve this problem, we must think of each cash flow stream. * There is an initial cash outflow of $7,000. Because this will occur now, the present value of this is -$7,000. * There is a cash outflow of $2,500 that will occur three years from now. The present value is calculated as -$2,500 \* 0.79383 = -$1,985 * There is an annuity of cash inflows of $1,500 each year for 8 years. The present value is calculated as $1,500 \* 5.74664 = $8,620 Thus, the net present value is the sum of each of these present values. -$7,000 - $1,985 + $8,620 = -$365 The NPV of the investment is -$365. Because the NPV is negative, it means the sum of the discounted cash inflows is less than the sum of the discounted cash outflows, so the company should not invest in the machine because it would receive a return that is less than the discount rate.

Question 49

Answer 49

The correct answer is $35. The correct answer formula, which should be entered into cell E3 is the following: =NPV(E2,B3:B10)+B2 There is one important thing to note about using the NPV formula. The formula itself does not include any cash flow at time 0 (today). Instead, the formula takes into account all future cash flows, and nets them back to the present value today, so if there are any cash flows at time 0 (today), those must be added or subtracted manually. Because the NPV is positive, even though it is very small, it means that the sum of the discounted cash inflows is greater than the sum of the discounted cash outflows, so the project would yield a return greater than the discount rate.

Question 50

Company X is considering investing in a new project. The new project requires an initial investment of $180,000, and is expected to generate annual after-tax net cash inflow of $25,000 for 15 years. The discount rate is 8%. What is the Net Present Value of the project? * Present value of $1 for 15 years at 8% is 0.31524 * Present value of an annuity *(form of investment)* of $1 for 15 years at 8% is 8.55948

Answer 50

The correct answer is: $33,987 NPV = (Initial investment) + Present value of operating cash flows = (-$180,000) + ($25,000 \* 8.55948) = $33,987

Question 51

Answer 51

The correct answer is: $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

Question 52

IRR

Answer 52

The IRR is the discount rate that sets the NPV of a project equal to zero. The IRR allows us to see the percentage rate that will be earned for a given set of cash flows. This method incorporates the time value of money as the NPV does. **_Calculate IRR: Using a Spreadsheet_** The function in a spreadsheet is: =IRR(values) * Values is an array of numbers for which to calculate the internal rate of return. Values must contain at least one positive value and one negative value. The order of values must be in the order of cash flows.

Question 53

Answer 53

The correct answer is 8.15% The correct answer formula, which should be entered into cell E4 is the following: =IRR(B2:B10) The IRR formula is an iterative calculation that operationally uses a guess-and-check method to find the correct discount rate that sets the NPV equal to zero. To test the solution, you can use the NPV formula and use the IRR as the discount rate to prove that the IRR indeed is the discount rate at which the NPV is equal to zero.

Question 54

payback period

Answer 54

The payback period tells us **how fast the investors can expect to have their money returned.** This metric is more useful for someone who is concerned about limiting the downside potential There is not a specific function in the spreadsheet, but we can use a spreadsheet to help with the calculation. The best way to calculate the payback period is to: * calculate the cumulative cash flows. * Another way to think of the payback period is that it is the “breakeven” point, or the point at which positive cash flows and negative cash flows incurred to date net to zero. By calculating the cumulative cash flows, it is easy to see when the cash flows flip from being negative to being positive. If it doesn’t flip exactly at a certain year, then you just need to find the portion of the following year that it takes to recover the remaining cash outlay.

Question 55

**Discounted Cash Flow VS. Discount Rate**

Answer 55

**Discounted Cash Flow** Valuation methodology that takes a company’s projected free cash flows and discounts them to arrive a present value. **Discount Rate** A percentage rate determined by a company used to calculate the present value for a stream of future cash flows. The discount rate is somewhat subjective and is meant to take all of the factors that impact the time value of money into account, e.g. opportunity cost, inflation, and risk.

Question 56

Question: Suppose you are considering buying a machine that costs $7,000. It will generate revenues of $1,500 for the next 3 years, and then $1,000 for following 5 years. What is the payback period of this investment?

Answer 56

The correct answer is 5.5 years. This means it will take 5.5 years for the undiscounted cash flows related to the investment to net to zero, or in other words, it will take 5.5 years for the company to recover the amount of their initial investment. The correct answer formula, which should be entered into cell F3 is the following: =A7-(C7/B8) Solution: To solve this problem, enter the following formula into cell F3:=A7-(C7/B8) Note that this formula takes the number of years before cumulative cash flows flip from being negative to being positive, and then adds the fraction of the year it takes for the remaining cash outlay to be recovered in the following year.

Question 57

Which of the following would NOT have an impact on the IRR of a project? * Weighted average cost of capital * Project Life span * Relevant cash flows * Initial investment

Answer 57

**Weighted average cost of capital** This is the correct answer! IRR is the discount rate at which the net present value of an investment equals zero. Weighted average cost of capital does not impact IRR.

Question 58

Which of the following statements is NOT true regarding Payback Period? * Payback Period is the length of time required to recover the cost of an investment. * A shorter Payback Period is preferable to longer Payback Period. * Payback Period is impacted by cash flows that occur after the initial cost is recovered. * Payback Period ignores the time value of money.

Answer 58

**Payback Period is impacted by cash flows that occur after the initial cost is recovered.** * This is the correct answer! This statement is NOT true. Payback Period only considers cash flows that occur before the initial cost is recovered and ignores any cash flows that occur after the payback period.

Question 59

Company Y is considering purchasing a new machine. The new machine has a cost of $50,000, and is expected to generate annual after-tax net cash inflow of $10,000. The useful life of the machine is 8 years. * NPV at 9% = $5,348 * NPV at 10% = $3,349 * NPV at 11% = $1,461 * NPV at 12% = -$324 * NPV at 13% = -$2,012 What is the Internal Rate of Return?

Answer 59

**The correct answer is: 11.5%** IRR is the discount rate at which the NPV of an investment equals zero. Because NPV at 11% is positive while NPV at 12% is negative, IRR must fall between 11% and 12%.

Question 60

**A project has a negative Net Present Value. Which of the following statements is true regarding this project?** * The project will not yield any positive cash flows in the future. * The sum of undiscounted cash flows is negative. * The IRR of the project is negative. * The IRR of the project is less than the WACC.

Answer 60

* The project will not yield any positive cash flows in the future. * This is not necessarily true. A project may yield positive cash flows but still have a negative NPV, as the NPV is the net present value of all relevant cash flows, both positive and negative, and including the initial outlay of cash. * The sum of undiscounted cash flows is negative. * This is not necessarily true. The sum of the project's undiscounted cash flows may be positive, but the project could still have a negative NPV, as the NPV uses discounted cash flows. * The IRR of the project is negative. * IRR is the discount rate at which the net present value of an investment equals zero. Therefore, the IRR in this case is less than the WACC, but not necessarily negative. * **The IRR of the project is less than the WACC.** * **This is the correct answer! IRR is the discount rate at which the net present value of an investment equals zero. Therefore: When NPV \< 0, IRR \< WACC. When NPV = 0, IRR = WACC. When NPV \> 0, IRR \> WACC.** **_WACC = weighted average cost of capital_**

Question 61

Answer 61

The correct answer is: 5.5 years Payback period is the period of time required to recover the cost of an investment. It ignores the time value of money. In this example, the sum of net cash flows of the first 5 years is $144,000. Payback Period = 5 + ($155,000 - $144,000)/$22,000 = 5.5 years.

Question 62

Answer 62

Question 63

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Question 64

Answer 64

Question 65

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Question 66

Answer 66

Question 67

Answer 67

Question 68

Which of the following would NOT be considered a relevant cash flow in determining if a company should invest in a new project? * The revenues expected to be generated by the new project several years after the project begins * The cost of hiring additional staff to run the new project * The cost of office space already owned with capacity to house the new project * The cost of software that needs to be acquired to run the new project

Answer 68

The cost of office space already owned with capacity to house the new project This is the correct answer! This is NOT a relevant cash flow. Because the office space is already owned, this cost is not incremental to the project and will be incurred regardless of the investment. Thus, it is not a relevant cash flow.

Question 69

Which of the following would NOT be considered a relevant cash flow in determining if a company should invest in a new project? * The travel cost for staff assigned to work on the new project * The cost already incurred to have a consulting firm do market research * The cost of research and development still needed to get the project to be feasible * The cost of marketing to sell the project once it reaches feasibility

Answer 69

* **The cost already incurred to have a consulting firm do market research** * This is the correct answer! This is NOT a relevant cash flow. Because the cost has already been incurred, it is considered a sunk cost. This cost is not incremental to the project and is not a relevant cash flow.

Question 70

In order to fairly compare different projects, the value of the cash flows has to be....

Answer 70

In order to fairly compare different projects, the value of the cash flows has to be **considered at the same time period.** For simplicity we often translate all cash flows to the value that they would be worth today, the “present value.” In order to make the calculation, you need a discount rate, which is the rate that would otherwise be available in the market or the rate that best captures the risk inherent in the project being evaluated.