Finance Chapter: Project Evaluation Techniques

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Questions and Answers

When comparing alternative projects, what is a preferred approach for clarity?

Calculate the overall project value combined

Compute cash flows for both options together

Compute the cash flows separately for each option (correct)

Use only the highest projected cash flow

What factor might require a different cost of capital for project options?

Different levels of market demand

Varying risk levels of each option (correct)

Identical risks across projects

Different expected cash inflows

What is typically added back to unlevered net income when calculating free cash flow?

Projected future income taxes

Amortization of intangible assets (correct)

Interest expenses from debt

Cash dividends paid to shareholders

Which of the following complicates free cash flow estimation?

Alternative depreciation methods Signup and view all the answers

What must be adjusted to determine a project's free cash flows from its unlevered net income?

Depreciation expenses and tax shields. Signup and view all the answers

Which factor is necessary to compute the value of equity in relation to a project's total value?

Cash flows generated after debt service. Signup and view all the answers

What is the primary reason that cash flow is necessary for a firm compared to earnings?

Cash flow is required for purchasing goods and funding investments. Signup and view all the answers

What does the depreciation tax shield refer to in capital budgeting?

The reduction in taxable income due to depreciation expenses. Signup and view all the answers

When calculating free cash flow, what adjustment must be made to incremental earnings?

Subtract capital expenditures and account for depreciation. Signup and view all the answers

In capital budgeting, what is the opportunity cost of capital?

The rate of return foregone from alternative investments. Signup and view all the answers

Why should opportunity cost be considered when evaluating a project?

It represents the value of resources that could be used elsewhere. Signup and view all the answers

What best describes the effect of capital expenditures on free cash flow?

They must be subtracted from incremental earnings. Signup and view all the answers

How does the value of debt relate to a firm's overall project valuation?

It influences the cost of capital and investment decisions. Signup and view all the answers

In the context of project evaluation, how do earnings differ from cash flow?

Earnings may include non-cash charges but do not reflect cash availability. Signup and view all the answers

Which of the following would NOT be included in the cash flow forecasts for a project?

Sunk costs already incurred. Signup and view all the answers

What does the term 'free cash flow' describe?

Cash flow remaining after funding capital investments. Signup and view all the answers

Study Notes

Capital Budgeting Fundamentals

Capital budgeting is the process of analyzing investment opportunities, ultimately deciding which ones to accept
Goal is to maximize firm value
NPV is the most accurate and reliable method for allocating resources
Projects with positive NPV should be accepted
Cash flows are crucial inputs for NPV calculation

Forecasting Earnings

Capital budget lists projects and investments for the coming year
Capital budgeting begins with forecasting future consequences
Revenues and costs are identified and analyzed
Goal determine NPV of cash flow consequences
Earnings aren't cash flow; incremental earnings are crucial for forecasted cash flows
Incremental earnings represent changes in earnings due to an investment
Revenue and cost estimates are assessed for the target market
Existing technologies can be adapted for new hardware
Software applications are developed to provide control over the home
Pre-existing equipment investments are required

Incremental Earnings Forecast

Using revenue and cost estimates, incremental earnings are forecasted
Sales occur over four years
Production costs are $110 per unit
Gross profit is calculated by subtracting production costs from sales
Operating expenses such as marketing and support are included
Research and development costs are one-time expenses
Depreciation is an expense that is not a cash expense; it represents the allocation of asset cost over time
Separate depreciation expenses, calculated using straight-line or other methods, are deducted
Income tax is calculated at the firm's marginal corporate tax rate
Unlevered net income = Earnings before interest and taxes × (1 - Marginal corporate tax rate)

Interest Expenses

Firm's interest expenses are not factored in when deciding on capital budgeting
Instead, the project is evaluated without considering the financing
The appropriate cost of capital is incorporated into the NPV calculation
Firm's treatment of capital expenditures for earnings is one reason earnings aren't a cash flow

Taxing Losses

Corporate tax rates are considered
Tax is calculated as Earnings before interest and taxes × Marginal corporate tax rate or EBIT × τ
Tax saving from depreciation is called depreciation tax shield
The tax rate used to compute depreciation expense is the marginal corporate tax rate
Losses can be used to reduce current taxable income
Tax loss carryforwards potentially reduce future taxable income

Project Externalities

Some projects might have indirect effects on other business activities
Some investments might displace sales of other products (called cannibalization)
Any changes to other business activities should be included in incremental earnings
Any changes in the costs, due to project externalities, should be considered as well

Taxes

Firms use their marginal corporate tax rates
Firms can deduct a portion of the project's purchase price when using MACRS (Modified Accelerated Cost Recovery System)
The Tax Cut and Jobs Act of 2017 allows firms to deduct a full portion of the purchase price as bonus depreciation

Sunk Costs

Sunk cost is any unrecoverable cost already incurred for which the firm is liable
Sunk costs are not factored into capital budgeting analysis
Sunk costs do not affect future cash flows, so they are irrelevant

Net Working Capital

Net working capital (NWC) is calculated as current assets less current liabilities
Components of NWC include cash, inventory, accounts receivable, and accounts payable
NWC changes in a project affect free cash flows
NWC changes should be included in free cash flow calculation

Free Cash Flow

Free cash flow represents the incremental effect of the capital budgeting project on the company's available cash
Free cash flow is calculated by adjusting earnings by removing non-cash expenses and including cash inflows
Cash flows are adjusted for capital investments and changes in working capital

Project Valuation/Analysis

NPV calculation calculates the difference between present value and the project cost
Goal is to identify the factors that most impact the project's NPV
Sensitivity and scenario analyses evaluate the impact of varying factors (i.e. costs, revenues) on the NPV
Break-even levels for parameters (sales or prices) are calculated to determine when NPV becomes zero
Different depreciation methods (MACRS, straight-line) impact NPV calculations as they affect the timing and magnitude of tax savings.
Terminal value is the value of the project beyond the explicit forecast horizon

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Description

This quiz explores various project evaluation techniques in finance, focusing on outsourcing vs. in-house production, cash flow analysis, and the calculation of free cash flow. Assess your understanding of key concepts like NPV, cost of capital adjustments, and the importance of accurate cash flow estimation. Ideal for finance students looking to solidify their grasp on project evaluation methods.