Chapter 12 Discussion Questions 12-1 What are the important administrative considerations in the capital budgeting Important administrative considerations relate to the search for and discovery of investment opportunities, the collection of data, the evaluation of projects d the reevaluation of prior d 12-2 Why does capital bud geting rely on analysis of cash flows rather than on net income? Cash flow rather than net income is used in capital budgeting analysis becaus the primary concern is with the amount of actual dollars generated For example, depreciation is subtracted out in arriving at net income, but this noncash deduction should be ad ded back in to determine cash flow or actual dollars generated What are the weaknesses of the pay back method? The weaknesses of the payback method are b. The concept fails to consider the time value of money od a. There is no consideration of inflows after the cutoff per 12-4 What is normally used as the d iscount rate in the net present value method? The cost of capital as determined in Chapter 11 12-5 What does the term mutually exclusive investments mean? The selection of one investment precludes the selection of other alternative Investments 12-6 How does the modified internal rate of return include concepts from both the trad itional internal rate and the net present value methods? The mod ified internal ratio of return calls for the determination of the interest rate that equates future inflows to the investment as does the trad itional internal rate or return. However, it incorporates the reinvestment rate assumption of the net present value method. That is that inflows are reinvested at the cost of
Chapter 12 Discussion Questions 12-1. What are the important administrative considerations in the capital budgeting process? Important administrative considerations relate to: the search for and discovery of investment opportunities, the collection of data, the evaluation of projects, and the reevaluation of prior decisions. 12-2. Why does capital budgeting rely on analysis of cash flows rather than on net income? Cash flow rather than net income is used in capital budgeting analysis because the primary concern is with the amount of actual dollars generated. For example, depreciation is subtracted out in arriving at net income, but this noncash deduction should be added back in to determine cash flow or actual dollars generated. 12-3. What are the weaknesses of the payback method? The weaknesses of the payback method are: a. There is no consideration of inflows after the cutoff period. b. The concept fails to consider the time value of money. 12-4. What is normally used as the discount rate in the net present value method? The cost of capital as determined in Chapter 11. 12-5. What does the term mutually exclusive investments mean? The selection of one investment precludes the selection of other alternative investments. 12-6. How does the modified internal rate of return include concepts from both the traditional internal rate and the net present value methods? The modified internal ratio of return calls for the determination of the interest rate that equates future inflows to the investment as does the traditional internal rate or return. However, it incorporates the reinvestment rate assumption of the net present value method. That is that inflows are reinvested at the cost of capital
If a corporation has projects that will earn more than the cost of capital, should it ration capital? From a purely economic viewpoint, a firm should not ration capital. The firm should be able to find add itional funds and increases its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost 12-8 What is the net present value profile? What three points should be determined to graph the profile? The net present value profile allows for the graphic portrayal of the net present value of a project at different discount rates. Net present values are shown along the vertical axis and discount rates are shown along the horizontal axis The points that must be determined to graph the profile are a. The net present value at zero discount rate b. The net present value as determined by a normal discount rate c. The internal rate of return for the investment How does an asset's ADr (asset depreciation range)relate to its mACRS The ADR represents the asset depreciation range or the expected physical life of the asset generally the midpoint of the range or life is utilized The longer the adr midpoint, the longer the MACrS category in which the asset is placed. However, most assets can still be written off more rapidly than the midpoint of the ADR. For example, assets with ADR midpoints of 10 yea 15 years can be placed in the 7-year MACRS category for depreciation s to purpos CopyrightC 2005 by The McGray-Hill Companies, Inc. S-422
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-422 12-7. If a corporation has projects that will earn more than the cost of capital, should it ration capital? From a purely economic viewpoint, a firm should not ration capital. The firm should be able to find additional funds and increases its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost. 12-8. What is the net present value profile? What three points should be determined to graph the profile? The net present value profile allows for the graphic portrayal of the net present value of a project at different discount rates. Net present values are shown along the vertical axis and discount rates are shown along the horizontal axis. The points that must be determined to graph the profile are: a. The net present value at zero discount rate. b. The net present value as determined by a normal discount rate. c. The internal rate of return for the investment. 12-9. How does an asset's ADR (asset depreciation range) relate to its MACRS category? The ADR represents the asset depreciation range or the expected physical life of the asset. Generally, the midpoint of the range or life is utilized. The longer the ADR midpoint, the longer the MACRS category in which the asset is placed. However, most assets can still be written off more rapidly than the midpoint of the ADR. For example, assets with ADR midpoints of 10 years to 15 years can be placed in the 7-year MACRS category for depreciation purposes
Problems Assume a corporation has earnings before depreciation and taxes of $90,000, and depreciation of $40,000, and that it has a 30 percent tax bracket Compute its cash flow using the format below Earnings before depreciation and taxes Earnings before taxes Earnings after taxes Depreciation Cash flow Solution: Earnings before depreciation and taxes $90000 Depreciation 40000 Earnings before taxes 50.000 Taxes(@ 30% 15000 Ear fter taxes $35,000 Depreciation 40.000 Cash flow $75000 S-423 oyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-423 Problems 12-1. Assume a corporation has earnings before depreciation and taxes of $90,000, and depreciation of $40,000, and that it has a 30 percent tax bracket. Compute its cash flow using the format below. Earnings before depreciation and taxes Depreciation Earnings before taxes Taxes @ 30% Earnings after taxes Depreciation Cash flow Solution: Earnings before depreciation and taxes $90,000 Depreciation –40,000 Earnings before taxes 50,000 Taxes @ 30% –15,000 Earnings after taxes $35,000 Depreciation +40,000 Cash flow $75,000
2 a. In problem 1, how much would cash flow be if there were only $10,000 in depreciation? All other factors are the same b. How much cash flow is lost due to the reduced depreciation between problems I and 2a? Solution: a. Earnings before depreciation and taxes $90000 Depreciation 10000 Earnings before taxes $80000 Taxes@ 30% 24000 Earnings after taxes $56.000 Depreciation +10000 Cash flow $66.000 b Cash flow(problem 1) $75.000 Cash flow(problem 2) 66.000 Difference in cash flow $9,000 CopyrightC 2005 by The McGray-Hill Companies, Inc. S-424
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-424 12-2. a. In problem 1, how much would cash flow be if there were only $10,000 in depreciation? All other factors are the same. b. How much cash flow is lost due to the reduced depreciation between problems 1 and 2a? Solution: a. Earnings before depreciation and taxes $90,000 Depreciation –10,000 Earnings before taxes $80,000 Taxes @ 30% –24,000 Earnings after taxes $56,000 Depreciation +10,000 Cash flow $66,000 b. Cash flow (problem 1) $75,000 Cash flow (problem 2) 66,000 Difference in cash flow $ 9,000
Assume a firm has earnings before depreciation and taxes of $200,000 and no depreciation. It is in a 40 percent tax bracket a. Compute its cash flow. b. Assume it has $200,000 in depreciation Recompute its cash flow c. How large a cash flow benefit d id the depreciation provide? d. Would the president of a firm on the New York Stock Exchange likely be satisfied with the earnings after taxes results in part c? Solution: a. Earnings before depreciation and taxes $200000 Depreciation 0 Earnings before taxes 200.000 xes 40% 80000 Earnings after taxes 120.000 Depreciation 0 Cash flow $120,000 b. Earnings before depreciation and taxes $200000 Depreciation 200000 Earnings before taxes Taxes@ 40% Earnings after taxes 000 Depreciation 200000 Cash flow $200000 S-425 oyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-425 12-3. Assume a firm has earnings before depreciation and taxes of $200,000 and no depreciation. It is in a 40 percent tax bracket. a. Compute its cash flow. b. Assume it has $200,000 in depreciation. Recompute its cash flow. c. How large a cash flow benefit did the depreciation provide? d. Would the president of a firm on the New York Stock Exchange likely be satisfied with the earnings after taxes results in part c? Solution: a. Earnings before depreciation and taxes $200,000 Depreciation – 0 Earnings before taxes 200,000 Taxes @ 40% – 80,000 Earnings after taxes 120,000 Depreciation – 0 Cash flow $120,000 b. Earnings before depreciation and taxes $200,000 Depreciation –200,000 Earnings before taxes 0 Taxes @ 40% 0 Earnings after taxes 0 Depreciation 200,000 Cash flow $200,000