Why is it important for the financial analyst to (a) focus on incremental cash flows, (b)
ignore financing costs, (c) consider taxes, and (d) adjust for non-cash expenses when
estimating a project’s relevant cash flows?
a. To properly evaluate the costs and benefits of a capital investment ...
Cash Flow and Capital Budgeting
Answers to Concept Review Questions
1. Why is it important for the financial analyst to (a) focus on incremental cash flows, (b)
ignore financing costs, (c) consider taxes, and (d) adjust for non-cash expenses when
estimating a project’s relevant cash flows?
a. To properly evaluate the costs and benefits of a capital investment project, a
manager must be able to identify the additional cash inflows and outflows that will
result solely from acceptance of the project, so only these incremental CFs are
important.
b. An analyst should ignore financing costs for individual projects, and instead should
use a single weighted average cost of capital for evaluating all capital investment
projects that have the same risk as the firm’s other assets. Otherwise, the analysts
will be entangling investment and capital structure (the mix of long-term debt and
equity) decisions.
c. Taxes influence the capital budgeting decision because they can change the net value
of cash flows received or paid out that result from accepting a project. Taxes on cash
inflows reduce the value of these receipts, while tax credits and deductions that result
from accepting a project increase its attractiveness.
d. Non-cash expenses are important if these reduce the taxes that must be paid on
incremental cash inflows. The most important non-cash expense for most firms is
depreciation, and this deduction works to reduce the tax liabilities of profitable firms.
2. Why do we consider changes in net working capital associated with a project to be cash
inflows or outflows rather than the absolute level of working capital?
Changes in net working capital are important. The company starts out with a certain
amount of working capital – since it already has this, it is not relevant to the cash flow
equation. If it needs to change the amount of working capital that it has, then that change
is relevant.
3. For what kinds of investments would terminal value account for a substantial fraction of
the total project NPV, and for what kinds of investments would terminal value be
relatively unimportant?
The higher the growth rate of cash flows, the higher the terminal value of the project. A
project where cash flows level off in time will have a much smaller terminal value.
4. What is meant by a potential investment’s relevant cash flows? What are sunk costs and
cannibalization, and do they affect the process of determining a proposed investment’s
incremental cash flows?
The relevant cash flows for an investment are its incremental, after-tax, cash flows, which
ignore financing costs and reflect adjustments for any noncash charges, typically
depreciation.
41
, 42 Y Chapter 9/Cash Flow and Capital Budgeting
A sunk cost is a cost that has already been paid and is therefore not recoverable.
Cannibalization is the “substitution effect” that frequently occurs when a firm introduces
a new product. Typically, some of the new product’s sales will come at the expense of the
firm’s existing products.
While sunk costs are irrelevant and should be ignored when determining an investment’s
incremental cash flows, the incremental cash outflows from existing product sales that
are cannibalized by a newer product should be taken into consideration when
considering a new investment.
5. A real estate development firm owns a fully leased 40-story office building. A tenant
recently moved its offices out of 2 stories of the building, leaving the space temporarily
vacant. If the real estate firm considers moving its own offices into this 40-story office
building, what cost should it assign for the space? Is the cost of the vacant space zero
because the firm paid for the building long ago, a cost that is sunk, or is there an
incremental opportunity cost?
The cost for the space is the opportunity cost of not renting it out to a new tenant. It will
lose the rentals it could have gained if it chooses to occupy the space with its own offices
6. Suppose that an analyst makes a mistake and calculates the NPV of an investment project
by discounting the project’s contribution to net income each year rather than by
discounting its relevant cash flows. Would you expect the NPV based on net income to be
higher or lower than the NPV calculated using the relevant cash flows?
NPV based on net income could be higher if the company has low depreciation and high
additional working capital and ongoing capital expenditures needed for the project. NPV
based on net income could be lower if the company had a substantial depreciation
expense that was not added back into cash flows.
7. Embedded in the analysis of the jazz-music CD proposal is an assumption about how
Classicaltunes.com’s customers will behave when they are able to choose from a new set
of CDs. What is that assumption?
The company is assuming that its customers will see value in the addition of jazz CDs and
will add jazz to their classical sections. Any customer’s choice to buy jazz instead of a
classical CD must be embedded in the incremental cash flows.
8. What other ways might Classicaltunes.com estimate the terminal value of this project?
Classicaltunes.com could have assumed a stable perpetuity, rather than a growing
perpetuity, which would have given it a lower terminal value.
9. Suppose that Congress passes a new MACRS schedule that reclassifies computers as 3-
year equipment rather than 5-year equipment. In general, what impact would this
legislation have on the project’s NPV?
This change would be an advantage to companies. They would be able to depreciate their
purchases faster, meaning there will be more depreciation, less taxable income and
therefore less in taxes. It is to a company’s benefit to depreciate equipment as quickly as
possible. In fact, assuming it had sufficient income, it would receive the most benefit by
not depreciating equipment, and simply expensing it when it occurred.
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