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Chapter 11 HW Questions Note: For each non-excel question, you must provide your source in the proper APA format. Reminder: If you DO NOT have a formula within your answer cell, it will not be marked correct! You must show your work within the excel formula! 1. Calculating project cash flows: Why do we use forecasted incremental after-tax free cash flows instead of forecasted accounting earnings in estimating the NPV of a project? 2. The FCF calculation: How do we calculate incremental after-tax free cash flows from forecasted earnings of a project? What are the common adjustment items? 3. The FCF calculation: How do we adjust for depreciation when we calculate incremental after-tax free cash flow from EBITDA? What is the intuition for the adjustment? 4. Nominal versus real cash flows: What is the difference between nominal and real cash flows? Which rate of return should we use to discount each type of cash flow? 5. Taxes and depreciation: What is the difference between average tax rate and marginal tax rate? Which one should we use in calculating incremental after-tax cash flows? 6. [EXCEL] Computing terminal-year FCF: Healthy Potions, Inc., a pharmaceutical company, bought a machine at a cost of $2 million five years ago that produces painreliever medicine. The machine has been depreciated over the past five years, and the current book value is $800,000. The company decides to sell the machine now at its market price of $1 million. The marginal tax rate is 30 percent. What are the relevant cash flows? How do they change if the market price of the machine is $600,000 instead? 7. Cash flows from operations: What are variable costs and fixed costs? What are some examples of each? How are these costs estimated in forecasting operating expenses? 8. Cash flows from operations: When forecasting operating expenses, explain the difference between a fixed cost and a variable cost. 9. [EXCEL] Investment cash flows: Zippy Corporation just purchased computing equipment for $20,000. The equipment will be depreciated using a five-year MACRS depreciation schedule. If the equipment is sold at the end of its fourth year for $12,000, what are the after-tax proceeds from the sale, assuming the marginal tax rate is 35 percent. 10. [EXCEL] Investment cash flows: Six Twelve, Inc., is considering opening up a new convenience store in downtown New York City. The expected annual revenue at the new store is $800,000. To estimate the increase in working capital, analysts estimate the ratio of cash and cash-equivalents to revenue to be 0.03 and the ratios of receivables, inventories, and payables to revenue to be 0.05, 0.10, and 0.04, respectively, in the same industry. What is the expected incremental cash flow related to working capital when the store is opened? 11. [EXCEL] Investment cash flows: Keswick Supply Company wants to set up a division that provides copy and fax services to businesses. Customers will be given 20 days to pay for such services. The annual revenue of the division is estimated to be $25,000. Assuming that the customers take the full 20 days to pay, what is the incremental cash flow associated with accounts receivable? 12. Expected cash flows: Define expected cash flows, and explain why this concept is important in evaluating projects. 13. Projects with different lives: Explain the concept of equivalent annual cost and how it is used to compare projects with different lives. 14. Replace an existing asset: Explain how we determine the optimal time to replace an existing asset with a new one. 15. Projects with different lives: If you had to choose between one project with an expected life of five years and a second project with an expected life of six years, how could you do this without using the equivalent annual cost concept? 11.6 Computing terminal-year FCF: Healthy Potions, Inc., a pharmaceutical company, bou a machine at a cost of $2,000,000 five years ago that produces pain-reliever medicine. machine has been depreciated over the past five years, and the current book value is $800,000. The company decides to sell the machine now at its market price of $1 millio The marginal tax rate is 30 percent. What are the relevant cash flows? How do they change if the market price of the machine is $600,000 instead? armaceutical company, bought ces pain-reliever medicine. The the current book value is its market price of $1 million. ash flows? How do they ad? 11.9 Investment cash flows: Zippy Corporation just purchased computing equipment for equipment will be depreciated using a five-year MACRS depreciation schedule. If at the end of its fourth year for $12,000, what are the after-tax proceeds from the sa marginal tax rate is 35 percent? hased computing equipment for $20,000. The CRS depreciation schedule. If the equipment is sold he after-tax proceeds from the sale, assuming the 11.10 Investment cash flows: Six Twelve Inc. is considering opening up a new convenience in downtown New York City. The expected annual revenue is $800,000. To estimate the increase in working capital, analysts estimate the ratio of cash and cash equivalents to revenue to be 0.03 and the ratio of receivables, inventories, and payables to revenue t 0.05, 0.10, and 0.04, respectively in the same industry. What is the incremental cash fl related to working capital when the store is opened? ning up a new convenience store $800,000. To estimate the sh and cash equivalents to and payables to revenue to be t is the incremental cash flows 11.11 Investment cash flows: Keswick Supply Company wants to set up a division that prov services to businesses. Customers will be given 20 days to pay for such services. The division is estimated to be $25,000. Assuming that the customers take the full 20 days incremental cash flow associated with accounts receivable? s to set up a division that provides copy and fax o pay for such services. The annual revenue of the stomers take the full 20 days to pay, what is the e? 1. We use forecasted incremental after tax free cash flows because they are more important than accounting earnings to access the value of an investment. Accounting earnings do not include non cash expenses like depreciation while cash flow includes them. It is the generation of cash that is important to decide worth of a project. Reference: Incremental Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 2. Some of the adjustment items are depreciation expenses and other non cash expenses. Interest expenses after giving tax effect are added and capital expenditures are deducted. Reference: Free Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 3. Depreciation is added back to EBITDA to calculate incremental after tax free cash flow. It is added back because it is a non cash expense. Reference: Free Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 4. Nominal cash flows are the cash flow without adjustment for inflation. While real cash flows are the cash flows after adjustment for inflation. Nominal cash flows should be discounted with cost of capital while real cash flows should be discounted with inflation adjusted cost of capital. Reference: Hanks, G. (n.d.). Nominal vs. Real Cash Flow. Retrieved from http://smallbusiness.chron.com/ 5. Average tax rate is calculated by dividing total taxes paid with the total taxable income. It is the average rate at which a tax payer is taxed. While marginal tax rate is the rate at which additional income will be taxed. We should use marginal tax rate for calculating incremental after-tax cash flows. Reference: Marginal and average tax rate, (n.d.). Retrieved from http://www.maxi-pedia.com/ 7. Variable costs are those cost which directly varies with the level of activity while fixed costs are those costs which remain constant within the relevant range of activity and do not change with production. Direct materials and direct labor cost are some of the example of variable cost. Depreciation, administrative salaries are example of fixed costs. Variable costs have to be adjusted according to the forecasted level of activity but fixed cost remains same in forecasting operating expenses. Reference: Variable costs and fixed costs. Retrieved from http://economics.fundamentalfinance.com/ 8. Variable cost remains same per unit of production. So when forecasting operating expenses they are calculated on the basis of forecasted level of activity. While fixed costs are predetermined and not depends on forecasted level of activity. Reference: Variable costs and fixed costs. Retrieved from http://economics.fundamentalfinance.com/ 12. Expected cash flows are the cash inflows that are likely to be generated by a project during its lifetime. This concept is important in evaluating projects because to make a capital investment decision expected cash flows are compared with the cost of the project to decided whether to invest or not. Reference: Net Cash Flow. Retrieved from http://www.investinganswers.com/ 13. Equivalent annual cost is the annual cost of operating and maintaining an asset over its lifetime. When comparing projects with different lives it is a widely used tool. Here annual expenses associated with a project is calculated and discounted on the basis of cost of capital to determine equivalent annual cost and then project with lower equivalent cost is selected. Reference: Equivalent Annual Cost. (n.d.). Retrieved from http://www.investopedia.com/ 14. Optimal time to replace an existing asset with the new one is when net cash flow generated by the new asset including the salvage value of the old asset for the remaining life of the old asset is higher than the cash inflow expected to be generated by the old asset. Reference: Asset investment decisions, (n.d.). Retrieved from http://kfknowledgebank.kaplan.co.uk/ 15. If the project is not likely to repeat in future then in place of equivalent cost concept we can use net present value method of capital budgeting decision. Reference: Equivalent Annual Cost. (n.d.). Retrieved from http://www.investopedia.com/ 1. We use forecasted incremental after tax free cash flows because they are more important than accounting earnings to access the value of an investment. Accounting earnings do not include non cash expenses like depreciation while cash flow includes them. It is the generation of cash that is important to decide worth of a project. Reference: Incremental Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 2. Some of the adjustment items are depreciation expenses and other non cash expenses. Interest expenses after giving tax effect are added and capital expenditures are deducted. Reference: Free Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 3. Depreciation is added back to EBITDA to calculate incremental after tax free cash flow. It is added back because it is a non cash expense. Reference: Free Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 4. Nominal cash flows are the cash flow without adjustment for inflation. While real cash flows are the cash flows after adjustment for inflation. Nominal cash flows should be discounted with cost of capital while real cash flows should be discounted with inflation adjusted cost of capital. Reference: Hanks, G. (n.d.). Nominal vs. Real Cash Flow. Retrieved from http://smallbusiness.chron.com/ 5. Average tax rate is calculated by dividing total taxes paid with the total taxable income. It is the average rate at which a tax payer is taxed. While marginal tax rate is the rate at which additional income will be taxed. We should use marginal tax rate for calculating incremental after-tax cash flows. Reference: Marginal and average tax rate, (n.d.). Retrieved from http://www.maxi-pedia.com/ 7. Variable costs are those cost which directly varies with the level of activity while fixed costs are those costs which remain constant within the relevant range of activity and do not change with production. Direct materials and direct labor cost are some of the example of variable cost. Depreciation, administrative salaries are example of fixed costs. Variable costs have to be adjusted according to the forecasted level of activity but fixed cost remains same in forecasting operating expenses. Reference: Variable costs and fixed costs. Retrieved from http://economics.fundamentalfinance.com/ 8. Variable cost remains same per unit of production. So when forecasting operating expenses they are calculated on the basis of forecasted level of activity. While fixed costs are predetermined and not depends on forecasted level of activity. Reference: Variable costs and fixed costs. Retrieved from http://economics.fundamentalfinance.com/ 12. Expected cash flows are the cash inflows that are likely to be generated by a project during its lifetime. This concept is important in evaluating projects because to make a capital investment decision expected cash flows are compared with the cost of the project to decided whether to invest or not. Reference: Net Cash Flow. Retrieved from http://www.investinganswers.com/ 13. Equivalent annual cost is the annual cost of operating and maintaining an asset over its lifetime. When comparing projects with different lives it is a widely used tool. Here annual expenses associated with a project is calculated and discounted on the basis of cost of capital to determine equivalent annual cost and then project with lower equivalent cost is selected. Reference: Equivalent Annual Cost. (n.d.). Retrieved from http://www.investopedia.com/ 14. Optimal time to replace an existing asset with the new one is when net cash flow generated by the new asset including the salvage value of the old asset for the remaining life of the old asset is higher than the cash inflow expected to be generated by the old asset. Reference: Asset investment decisions, (n.d.). Retrieved from http://kfknowledgebank.kaplan.co.uk/ 15. If the project is not likely to repeat in future then in place of equivalent cost concept we can use net present value method of capital budgeting decision. Reference: Equivalent Annual Cost. (n.d.). Retrieved from http://www.investopedia.com/ 1. We use forecasted incremental after tax free cash flows because they are more important than accounting earnings to access the value of an investment. Accounting earnings do not include non cash expenses like depreciation while cash flow includes them. It is the generation of cash that is important to decide worth of a project. Reference: Incremental Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 2. Some of the adjustment items are depreciation expenses and other non cash expenses. Interest expenses after giving tax effect are added and capital expenditures are deducted. Reference: Free Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 3. Depreciation is added back to EBITDA to calculate incremental after tax free cash flow. It is added back because it is a non cash expense. Reference: Free Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 4. Nominal cash flows are the cash flow without adjustment for inflation. While real cash flows are the cash flows after adjustment for inflation. Nominal cash flows should be discounted with cost of capital while real cash flows should be discounted with inflation adjusted cost of capital. Reference: Hanks, G. (n.d.). Nominal vs. Real Cash Flow. Retrieved from http://smallbusiness.chron.com/ 5. Average tax rate is calculated by dividing total taxes paid with the total taxable income. It is the average rate at which a tax payer is taxed. While marginal tax rate is the rate at which additional income will be taxed. We should use marginal tax rate for calculating incremental after-tax cash flows. Reference: Marginal and average tax rate, (n.d.). Retrieved from http://www.maxi-pedia.com/ 7. Variable costs are those cost which directly varies with the level of activity while fixed costs are those costs which remain constant within the relevant range of activity and do not change with production. Direct materials and direct labor cost are some of the example of variable cost. Depreciation, administrative salaries are example of fixed costs. Variable costs have to be adjusted according to the forecasted level of activity but fixed cost remains same in forecasting operating expenses. Reference: Variable costs and fixed costs. Retrieved from http://economics.fundamentalfinance.com/ 8. Variable cost remains same per unit of production. So when forecasting operating expenses they are calculated on the basis of forecasted level of activity. While fixed costs are predetermined and not depends on forecasted level of activity. Reference: Variable costs and fixed costs. Retrieved from http://economics.fundamentalfinance.com/ 12. Expected cash flows are the cash inflows that are likely to be generated by a project during its lifetime. This concept is important in evaluating projects because to make a capital investment decision expected cash flows are compared with the cost of the project to decided whether to invest or not. Reference: Net Cash Flow. Retrieved from http://www.investinganswers.com/ 13. Equivalent annual cost is the annual cost of operating and maintaining an asset over its lifetime. When comparing projects with different lives it is a widely used tool. Here annual expenses associated with a project is calculated and discounted on the basis of cost of capital to determine equivalent annual cost and then project with lower equivalent cost is selected. Reference: Equivalent Annual Cost. (n.d.). Retrieved from http://www.investopedia.com/ 14. Optimal time to replace an existing asset with the new one is when net cash flow generated by the new asset including the salvage value of the old asset for the remaining life of the old asset is higher than the cash inflow expected to be generated by the old asset. Reference: Asset investment decisions, (n.d.). Retrieved from http://kfknowledgebank.kaplan.co.uk/ 15. If the project is not likely to repeat in future then in place of equivalent cost concept we can use net present value method of capital budgeting decision. Reference: Equivalent Annual Cost. (n.d.). Retrieved from http://www.investopedia.com/ 1. We use forecasted incremental after tax free cash flows because they are more important than accounting earnings to access the value of an investment. Accounting earnings do not include non cash expenses like depreciation while cash flow includes them. It is the generation of cash that is important to decide worth of a project. Reference: Incremental Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 2. Some of the adjustment items are depreciation expenses and other non cash expenses. Interest expenses after giving tax effect are added and capital expenditures are deducted. Reference: Free Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 3. Depreciation is added back to EBITDA to calculate incremental after tax free cash flow. It is added back because it is a non cash expense. Reference: Free Cash Flow. (n.d.). Retrieved from http://www.investopedia.com/ 4. Nominal cash flows are the cash flow without adjustment for inflation. While real cash flows are the cash flows after adjustment for inflation. Nominal cash flows should be discounted with cost of capital while real cash flows should be discounted with inflation adjusted cost of capital. Reference: Hanks, G. (n.d.). Nominal vs. Real Cash Flow. Retrieved from http://smallbusiness.chron.com/ 5. Average tax rate is calculated by dividing total taxes paid with the total taxable income. It is the average rate at which a tax payer is taxed. While marginal tax rate is the rate at which additional income will be taxed. We should use marginal tax rate for calculating incremental after-tax cash flows. Reference: Marginal and average tax rate, (n.d.). Retrieved from http://www.maxi-pedia.com/ 7. Variable costs are those cost which directly varies with the level of activity while fixed costs are those costs which remain constant within the relevant range of activity and do not change with production. Direct materials and direct labor cost are some of the example of variable cost. Depreciation, administrative salaries are example of fixed costs. Variable costs have to be adjusted according to the forecasted level of activity but fixed cost remains same in forecasting operating expenses. Reference: Variable costs and fixed costs. Retrieved from http://economics.fundamentalfinance.com/ 8. Variable cost remains same per unit of production. So when forecasting operating expenses they are calculated on the basis of forecasted level of activity. While fixed costs are predetermined and not depends on forecasted level of activity. Reference: Variable costs and fixed costs. Retrieved from http://economics.fundamentalfinance.com/ 12. Expected cash flows are the cash inflows that are likely to be generated by a project during its lifetime. This concept is important in evaluating projects because to make a capital investment decision expected cash flows are compared with the cost of the project to decided whether to invest or not. Reference: Net Cash Flow. Retrieved from http://www.investinganswers.com/ 13. Equivalent annual cost is the annual cost of operating and maintaining an asset over its lifetime. When comparing projects with different lives it is a widely used tool. Here annual expenses associated with a project is calculated and discounted on the basis of cost of capital to determine equivalent annual cost and then project with lower equivalent cost is selected. Reference: Equivalent Annual Cost. (n.d.). Retrieved from http://www.investopedia.com/ 14. Optimal time to replace an existing asset with the new one is when net cash flow generated by the new asset including the salvage value of the old asset for the remaining life of the old asset is higher than the cash inflow expected to be generated by the old asset. Reference: Asset investment decisions, (n.d.). Retrieved from http://kfknowledgebank.kaplan.co.uk/ 15. If the project is not likely to repeat in future then in place of equivalent cost concept we can use net present value method of capital budgeting decision. Reference: Equivalent Annual Cost. (n.d.). Retrieved from http://www.investopedia.com/