Podcast
Questions and Answers
What is the Bottom-Up Approach to calculating Operating Cash Flow?
What is the Bottom-Up Approach to calculating Operating Cash Flow?
- Calculating cash flow before applying tax effects
- Starting with sales and subtracting all costs
- Starting with net income and adding back noncash deductions (correct)
- Beginning with depreciation and adding back operating expenses
Which of the following best describes Equivalent Annual Cost (EAC)?
Which of the following best describes Equivalent Annual Cost (EAC)?
- A way to convert present value of costs into an annual figure (correct)
- The process of estimating tax effects from capital investments
- A method to assess total cash flow over a project's life
- A calculation for determining cash flow from sales only
How should operating cash flows be considered when evaluating cost-cutting proposals?
How should operating cash flows be considered when evaluating cost-cutting proposals?
- They must include capital spending, tax effects, and savings (correct)
- They are only relevant if depreciation expenses are significant
- They should only focus on initial investments and ignore ongoing costs
- They should be excluded as they are constant across proposals
In using the Tax Shield Approach to Operating Cash Flow, what are the two components of cash flow?
In using the Tax Shield Approach to Operating Cash Flow, what are the two components of cash flow?
When setting a bid price for an investment, what is essential to ensure?
When setting a bid price for an investment, what is essential to ensure?
What is the primary purpose of considering both negative and positive spillover effects when evaluating new projects?
What is the primary purpose of considering both negative and positive spillover effects when evaluating new projects?
Which of the following best describes Net Working Capital (NWC)?
Which of the following best describes Net Working Capital (NWC)?
What happens to Net Working Capital as a project concludes?
What happens to Net Working Capital as a project concludes?
Why are financing costs excluded in project cash flow analysis?
Why are financing costs excluded in project cash flow analysis?
How should financing decisions be viewed in relation to project evaluation?
How should financing decisions be viewed in relation to project evaluation?
What do pro forma financial statements primarily summarize?
What do pro forma financial statements primarily summarize?
Which element is least likely to be considered part of the initial investment in NWC?
Which element is least likely to be considered part of the initial investment in NWC?
What key factor influences how project cash flows are distributed between owners and creditors?
What key factor influences how project cash flows are distributed between owners and creditors?
What is the cash revenue when sales are $500 and accounts receivable increase by $30?
What is the cash revenue when sales are $500 and accounts receivable increase by $30?
How does depreciation primarily impact cash flows?
How does depreciation primarily impact cash flows?
What is the initial investment in the MMCC project?
What is the initial investment in the MMCC project?
What is the expected salvage value of the equipment after eight years, based on the initial cost?
What is the expected salvage value of the equipment after eight years, based on the initial cost?
Which of the following best describes the Net Present Value (NPV) of the project?
Which of the following best describes the Net Present Value (NPV) of the project?
What is the required return rate for the MMCC project?
What is the required return rate for the MMCC project?
What is the internal rate of return (IRR) for the MMCC project?
What is the internal rate of return (IRR) for the MMCC project?
What happens if the sale price is below the book value in terms of tax implications?
What happens if the sale price is below the book value in terms of tax implications?
What is the primary characteristic of relevant cash flows in project evaluation?
What is the primary characteristic of relevant cash flows in project evaluation?
What does the term 'incremental cash flows' refer to?
What does the term 'incremental cash flows' refer to?
Which principle allows for the evaluation of a project's own merits independently of other projects?
Which principle allows for the evaluation of a project's own merits independently of other projects?
Why is it often not practical to calculate total future cash flows for the entire firm when evaluating a project?
Why is it often not practical to calculate total future cash flows for the entire firm when evaluating a project?
What type of cash flows are not relevant for project evaluation?
What type of cash flows are not relevant for project evaluation?
What is a common pitfall when identifying incremental cash flows?
What is a common pitfall when identifying incremental cash flows?
What is the significance of considering only incremental cash flows?
What is the significance of considering only incremental cash flows?
Why is the stand-alone principle beneficial in project evaluation?
Why is the stand-alone principle beneficial in project evaluation?
What defines a sunk cost?
What defines a sunk cost?
Which scenario best illustrates opportunity cost?
Which scenario best illustrates opportunity cost?
Why should the market value of a resource be considered in project evaluation?
Why should the market value of a resource be considered in project evaluation?
What are side effects in project management?
What are side effects in project management?
When is erosion relevant to a project?
When is erosion relevant to a project?
Which of the following best describes erosion?
Which of the following best describes erosion?
What characteristic should opportunity costs have?
What characteristic should opportunity costs have?
What is a common misconception about sunk costs?
What is a common misconception about sunk costs?
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Study Notes
Identifying Relevant Cash Flows
- Relevant Cash Flows: Cash flows directly tied to the decision to take on a project, influencing future cash flows of the firm.
- Incremental Cash Flows: The difference between the firm's future cash flows with and without the project - only changes matter.
- Stand-Alone Principle: Evaluates a project in isolation, treating it as a "minifirm" with its own revenues, costs, and cash flows.
Avoiding Common Mistakes in Cash Flow Analysis
- Sunk Costs: Costs already incurred and cannot be recovered, irrelevant for investment decisions. For example, consulting fees paid for a project evaluation.
- Opportunity Costs: The value sacrificed by choosing one investment over another, not an out-of-pocket expense. For example, the potential value of an old cotton mill if it were sold instead of converted into condominiums.
- Side Effects and Erosion: Projects can impact other areas of the firm, positively or negatively. Erosion occurs when a new project reduces the cash flow of existing projects. For example, shortened DVD release times hurting movie theater profits but boosting DVD sales.
- Net Working Capital (NWC): Investment in short-term assets like cash, inventories, and accounts receivable, crucial for project support. Initial investment in NWC is required upfront, but recovered at the project's end as assets are liquidated.
- Excluding Financing Costs: Financing costs like interest, dividends, and principal repayment are not included in project evaluation, as they impact cash flow distribution, not the generation of cash flow. Financing decisions are analyzed separately.
Pro Forma Financial Statements and Project Cash Flows
- Pro forma financial statements provide projections of future operations, summarizing key information like sales, costs, and investments.
- Operating Cash Flow (OCF):
- Calculated with different approaches: Top-down, bottom-up, and tax shield approach.
- Crucial component of project evaluation.
- Impacts tax liability and overall cash flows.
- Depreciation: Calculated using Modified Accelerated Cost Recovery System (MACRS), allowing for accelerated depreciation. This affects tax liability and cash flows.
- Book Value vs. Market Value: Depreciation is calculated without considering market value, potentially leading to taxable recapture or tax savings when an asset is sold.
Special Cases of Discounted Cash Flow Analysis
- Evaluating Cost-Cutting Proposals: Focus on incremental cash flows, including capital spending, operating cash flows, and tax effects. NPV analysis is used to assess the profitability of the proposal.
- Setting the Bid Price: Determine the lowest price acceptable to achieve a desired return on investment, using NPV as a benchmark. This involves calculating required operating cash flow.
- Evaluating Equipment Options with Different Lives: Equivalent Annual Cost (EAC) converts the present value of costs into an annual amount, facilitating comparisons between options with different service lives.
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