Cash Flow Analysis and Forecasting
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Questions and Answers

What determines whether a cost is considered a sunk cost in capital budgeting decisions?

  • The cost must have been incurred last year.
  • The cost must relate directly to an upcoming project.
  • The cost must be recoverable in the future.
  • The cost has already been spent and cannot be recovered. (correct)

    • What is an opportunity cost in the context of capital budgeting?

  • The direct costs associated with implementing a project.
  • The total capital required to finance the project.
  • The fixed overhead costs that do not vary with project decisions.
  • The opportunities lost from not pursuing alternative projects. (correct)

    • When analyzing cash flows in capital budgeting, what should be excluded from incremental cash flows?

  • Sunk costs incurred prior to the project. (correct)
  • Future projected revenues from the project.
  • Costs that will be realized after the conclusion of the project.
  • Costs associated directly with the project.

    • What is the formula for calculating the relationship between real rate, nominal rate, and inflation rate?

    <p>real rate = (1 + nominal rate) / (1 + inflation rate) - 1 (D)</p> Signup and view all the answers

    In capital budgeting, what constitutes an acceptable method for adjusting for tax effects on terminal loss?

    <p>Deducting terminal loss directly from taxable income. (B)</p> Signup and view all the answers

    What does a positive NPV indicate regarding a project?

    <p>The project is expected to generate more value than it costs. (B)</p> Signup and view all the answers

    How is cash flow calculated in relation to depreciation?

    <p>Cash flow is found by adding back the depreciation charge to profits. (C)</p> Signup and view all the answers

    What should be done if the IRR of a project is lower than the opportunity cost of capital?

    <p>The project should be rejected. (A)</p> Signup and view all the answers

    Which aspect is crucial when forecasting cash flows for project valuation?

    <p>Inclusion of both cash revenues and investment expenditures. (D)</p> Signup and view all the answers

    What does the term 'changes in net working capital' primarily refer to?

    <p>The adjustments in current assets and current liabilities over time. (A)</p> Signup and view all the answers

    What is the main difference between profits and cash flows in accounting?

    <p>Profits include all income, while cash flows focus only on cash transactions. (A)</p> Signup and view all the answers

    Which of the following statements about incremental cash flows is true?

    <p>Incremental CFs represent the changes due to accepting a project. (A)</p> Signup and view all the answers

    What should be included when calculating incremental cash flows?

    <p>Indirect effects such as cannibalization or sales creation. (C)</p> Signup and view all the answers

    A firm is analyzing a new project. Which of the following is an example of a sunk cost?

    <p>Previous research and development expenses for a now-abandoned project. (B)</p> Signup and view all the answers

    In the context of net working capital, which of the following best describes changes in net working capital?

    <p>The adjustments of current assets and current liabilities relevant to the project. (D)</p> Signup and view all the answers

    What is the effect of depreciation on operating cash flows?

    <p>Depreciation has no impact on operating cash flows since it’s a non-cash expense. (B)</p> Signup and view all the answers

    Which of the following correctly reflects the decision to accept a project based on net present value (NPV)?

    <p>Accept the project if the NPV is greater than zero. (B)</p> Signup and view all the answers

    How should deferred revenue be treated in cash flow analysis?

    <p>Include it as cash flow when it is earned. (C)</p> Signup and view all the answers

    Flashcards

    Sunk Cost

    A cost that has already been incurred and cannot be recovered, irrelevant for future decisions.

    Opportunity Cost

    The potential revenue lost from an alternative use of an asset when pursuing a project.

    Incremental Cash Flows

    Additional cash flows directly associated with a project, excluding sunk and non-incremental costs.

    Financing Decisions

    Separate analysis of how a project will be funded, distinct from investment analysis.

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    Discounting Cash Flows

    The process of lowering future cash flows to their present value using interest rates.

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    NPV

    Net Present Value; calculated as PV of cash flows minus initial investment. If NPV > 0, accept project.

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    IRR

    Internal Rate of Return; the discount rate making NPV equal to zero. Accept if IRR > opportunity cost.

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    Opportunity Cost of Capital

    The return expected from an investment, serving as the discount rate in NPV calculations.

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    Depreciation

    The allocation of the capital expense over time, affecting cash flow calculations but not accounting income directly.

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    Cash Flow vs. Profit

    Cash flow includes actual cash in/out, while profit considers accounting adjustments like depreciation.

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    Cash Flow (CF)

    The net amount of cash being transferred in and out of a business over a period.

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    Accounting Income

    The profit measured by accounting standards, which can include non-cash revenues.

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    NPV (Net Present Value)

    The difference between the present value of cash inflows and outflows over time.

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    Cannibalization

    When a new project reduces sales of existing products.

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    Sales Creation

    When a new project enhances sales of existing products.

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    Study Notes

    Cash Flow Analysis

    • Cash flow analysis involves evaluating the project's cash flows from the initial investment to determine if the project is worth undertaking.
    • Net Present Value (NPV): NPV is the present value of all future cash flows from a project minus the initial investment. If NPV is positive, the project is worth more than its cost and should be accepted. Otherwise, it should be rejected. The discount rate is the opportunity cost of capital.

    Forecasting CFs and Discounting CFs

    • To calculate cash flow (CF), add back depreciation and subtract new expenditure on projects.
    • Example: A $100,000 capital investment is a cash outflow, but depreciation isn't deducted immediately. Accountants depreciate the cost over several years, deducting the depreciation from the cash flow.
    • Profits versus Cash Flows: Accountants record profits as earned, not when customer pays their bills. CFs recognize when the payment is received or a transaction occurs.
    • Incremental CFs: These are the changes in cash flow that directly result from accepting a project.
      • CFs with project - CFs without project = Incremental CFs
    • Look for incremental benefits, asking if the cash flow would exist if the project wasn't undertaken. If no, then include it in calculations. If yes, exclude the cash flow.
    • Include indirect effects (side effects) in the analysis to forecast incremental CFs, and track out all indirect effects.
      • Cannibalization: a new product might hurt sales of an existing product (e.g., a new phone model may decrease sales of older models).
      • Sales creation: a new product may help increase sales of existing ones (e.g., a new route into a new airport would increase traffic and revenue streams).
    • Ignore sunk costs: These are costs already incurred and are not relevant to the current capital budgeting decision.
    • Include opportunity costs: if using an asset in a project, potential revenue from other uses is lost. This is considered a cost.
    • Only include overhead costs directly incurred by the project as part of incremental cash flows.

    Separate Investment and Financing Decisions

    • Evaluate the project, assuming all-equity financing.
    • Undertake a separate analysis of the financing decision.

    Discounting Nominal CFs at the Nominal Interest Rate

    • To discount nominal cash flows at the nominal interest rate, you need to account for the inflation rate using the following formula: (1+real rate) = (1+nominal rate)/(1+inflation rate)
    • If the inflation rate is positive, then the real rate will always be smaller than the nominal rate.
    • If you discount nominal cash flows with a real rate, then the result will be an overestimation of NPV.
    • If you discount real cash flows with a nominal rate, then the result will be an underestimation of NPV.

    Calculating CFs

    • Project CF is the sum of:

      • Investment in fixed assets (e.g., plant, equipment).
      • Investment in working capital.
      • CF from operations.

    • Total CF = Cash flow from investment in plant and equipment + cash flow from investment in working capital + cash flow from operations.

    • Capital Investment: Initial investments in fixed assets are cash outflows. If machinery is sold when a project finishes, the sale price (less taxes) is a cash inflow.

    • Investment in Working Capital (NWC): Working capital (NWC) is the difference between current assets and current liabilities. A new project requiring additional working capital is a cash outflow; a decrease is a cash inflow.

    • Cash flow from operations: Cash generated through normal business activities. Calculations are as follows:

      • CF = revenues - cash expenses - taxes
      • CF = net income + depreciation
      • CF = (revenues - cash expenses) × (1 - tax rate) + (depreciation × tax rate)

    Tax Shields

    • When calculating taxable income, businesses are allowed to deduct amounts for depreciation (CCA) on depreciable assets.
    • Taxable Income = Revenues - Expenses - CCA
    • CCA tax shield = CCA × tax rate

    Asset Class System

    • All eligible depreciable assets are grouped into specific asset classes by the CRA (Canadian Revenue Agency).
    • Each asset class has a prescribed CCA rate.
    • The undepreciated capital cost (UCC) is the balance remaining in an asset class that has not yet been depreciated that year.
    • CCA = UCC × CCA rate
    • The half-year rule applies in Canada; only one-half of the purchase cost of the asset is to be used in the calculation of the CCA in the year of the purchase. The remaining half is added to the asset class the following year.

    Project Valuation: An Example

    • Various examples show how to calculate NPV including capital investments, working capital, operations and CCA tax shields under different scenarios.

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    Related Documents

    Ch 9 Cash Flow Analysis PDF

    Description

    Explore the fundamental concepts of cash flow analysis, including evaluating cash flows and understanding Net Present Value (NPV). This quiz covers the intricacies of forecasting cash flows, depreciation, and the difference between profits and cash flows, providing a solid foundation in financial analysis.

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