Finance 201 Brau Exam 4 flashcards

Question 1

What is the primary goal of a capital budgeting problem?

Accepted Answer

The primary goal is to decide whether to invest in a new project by evaluating its cash flows, assessing its risk, and making an accept/reject decision.

Question 2

What are the three main steps in evaluating a capital budgeting project?

Accepted Answer

The three main steps are: evaluating cash flows, assessing project risk, and making an accept/reject decision.

Question 3

Define Initial Outlay.

Accepted Answer

The initial outlay is the total cash outflow required at the very beginning (time 0) of a project, including the purchase price, installation costs, and any increase in net working capital.

Question 4

What is included in the depreciable basis of an asset?

Accepted Answer

The depreciable basis includes the purchase price of the asset plus any costs necessary to get it ready for use, such as shipping and installation costs.

Question 5

How is Net Working Capital (NWC) treated in the initial outlay?

Accepted Answer

An increase in NWC at time 0 is a required investment that is not depreciated and has no immediate tax implications, but it is part of the total initial outlay.

Question 6

What is a differential cash flow?

Accepted Answer

Differential cash flows are the annual incremental cash flows generated by a project throughout its operational life, reflecting changes in revenues, costs, and taxes.

Question 7

How is annual depreciation calculated using simplified straight-line depreciation?

Accepted Answer

Annual depreciation is calculated by dividing the depreciable basis of the asset by its useful life.

Question 8

How are incremental earnings before taxes (EBT) calculated?

Accepted Answer

EBT is calculated by subtracting incremental operating costs and depreciation expense from incremental revenues.

Question 9

Why is depreciation added back to net income when calculating differential cash flow?

Accepted Answer

Depreciation is added back because it is a non-cash expense; adding it back converts net income (earnings after tax) into actual cash flow.

Question 10

What components make up terminal cash flows?

Accepted Answer

Terminal cash flows include the final year's operating cash flow, the after-tax proceeds from selling the asset, and the recovery of net working capital.

Question 11

How is the after-tax salvage value calculated?

Accepted Answer

After-tax salvage value is the salvage value minus any taxes owed on the capital gain (salvage value minus book value, if positive).

Question 12

What happens to the net working capital investment at the end of the project?

Accepted Answer

The initial investment in net working capital is typically recaptured at the end of the project, providing a cash inflow.

Question 13

What is the total cash flow at the end of a project's life?

Accepted Answer

It is the sum of the final year's differential cash flow and the total terminal cash flow (after-tax salvage value plus NWC recovery).

Question 14

How is the project's discount rate determined if its risk is similar to the firm's overall risk?

Accepted Answer

If the project's risk is similar to the firm's overall risk, the discount rate is set equal to the firm's cost of capital.

Question 15

What is the purpose of assessing project risk?

Accepted Answer

Assessing project risk helps determine the appropriate discount rate to use for evaluating the project's cash flows and making a sound investment decision.

Question 16

What is the formula for Net Present Value (NPV)?

Accepted Answer

NPV = $\sum_{t=0}^{n} \frac{CF_t}{(1+r)^t}$, where $CF_t$ is the cash flow at time $t$, $r$ is the discount rate, and $n$ is the project's life.

Question 17

How is the initial outlay represented when calculating NPV?

Accepted Answer

The initial outlay is entered as a negative value at time 0, representing a cash outflow.

Question 18

What does a positive NPV indicate?

Accepted Answer

A positive NPV indicates that the project is expected to increase firm value because the present value of its cash inflows exceeds the present value of its cash outflows.

Question 19

What does a negative NPV indicate?

Accepted Answer

A negative NPV indicates that the project is expected to decrease firm value because the present value of its cash outflows exceeds the present value of its cash inflows.

Question 20

What is the NPV decision rule?

Accepted Answer

The NPV decision rule states that a project with a positive NPV should be accepted, and a project with a negative NPV should be rejected.

Question 21

What is the depreciable basis for the swizzle-stick machine?

Accepted Answer

The depreciable basis is $610,000 ($587,000 purchase price + $23,000 installation costs).

Question 22

What is the total initial outlay for the swizzle-stick machine project?

Accepted Answer

The total initial outlay is $635,000 ($610,000 depreciable basis + $25,000 increase in NWC).

Question 23

What is the annual depreciation expense for the swizzle-stick machine?

Accepted Answer

The annual depreciation expense is $122,000 ($610,000 depreciable basis / 5 years).

Question 24

What is the annual differential cash flow for the swizzle-stick machine project (before considering terminal flows)?

Accepted Answer

The annual differential cash flow is $138,800 (calculated as $16,800 net income + $122,000 depreciation).

Question 25

What is the book value of the swizzle-stick machine at the end of year 5?

Accepted Answer

The book value is $0, as the entire $610,000 depreciable basis has been depreciated over the 5-year life.

Question 26

What is the after-tax cash inflow from selling the swizzle-stick machine?

Accepted Answer

The after-tax cash inflow is $45,000 ($75,000 salvage value - $30,000 tax on capital gain).

Question 27

What is the total cash flow at the end of year 5 for the swizzle-stick machine project?

Accepted Answer

The total cash flow at year 5 is $208,800 ($138,800 final year operating cash flow + $70,000 terminal cash flow).

Question 28

What is the project's cash flow timeline for the swizzle-stick machine?

Accepted Answer

Time 0: -$635,000; Years 1-4: $138,800 each year; Year 5: $208,800.

Question 29

What is the calculated NPV for the swizzle-stick machine project?

Accepted Answer

The NPV is -$134,918.50, calculated using the project's cash flows and a 15% discount rate.

Question 30

Should the swizzle-stick machine project be accepted based solely on the NPV criterion?

Accepted Answer

No, the project should be rejected because its NPV is negative, indicating it is expected to destroy firm value.

Question 31

Can qualitative factors override a negative NPV decision?

Accepted Answer

Yes, strategic or qualitative factors can sometimes influence a decision to accept a project even if its NPV is negative, though the NPV analysis itself suggests rejection.

Question 32

What is the relationship between book value and salvage value in determining taxable gain?

Accepted Answer

A taxable gain occurs if the salvage value (sale price) is greater than the book value; the tax is calculated on this difference.