2
FINA 5320 Exam 2 with precise detailed || || || || || || ||
solutions
What is capital budgeting - ✔✔the process used to evaluate and select long-term investments
|| || || || || || || || || || || || || ||
consistent with the goal of owner wealth maximization. || || || || || || ||
what are captial expendirtures - ✔✔outlays made by the firm that are expected to produce
|| || || || || || || || || || || || || || ||
benefits over the long term (a period greater than one year). Not all capital expenditures are made
|| || || || || || || || || || || || || || || || ||
for fixed assets.
|| ||
conventional cash flow pattern - ✔✔consists of an initial outflow followed by a series of inflows
|| || || || || || || || || || || || || || ||
nonconventional cash flow pattern - ✔✔any pattern in which an initial outlay is not followed by a || || || || || || || || || || || || || || || || ||
series of inflows. || ||
The primary motives for making capital expenditures include: - ✔✔-Expansion—increasing the
|| || || || || || || || || || ||
productive capacity of the firm, usually through the acquisition of fixed assets.
|| || || || || || || || || || ||
• Replacement—replacing existing assets with new or more advanced assets that provide the same
|| || || || || || || || || || || || ||
function.
||
• Renewal—rebuilding or overhauling existing assets to improve efficiency.
|| || || || || || || ||
captial budgeting projects should be evaluated using - ✔✔incremental after tax cash flows
|| || || || || || || || || || || ||
The three components of cash flow for any project are - ✔✔(1) initial investment, (2) operating
|| || || || || || || || || || || || || || || ||
cash flows, and (3) terminal cash flows.
|| || || || || ||
Relevant cash flows - ✔✔any and all changes in the firm's future cash flows that are a direct
|| || || || || || || || || || || || || || || || || ||
consequence of taking the project || || || ||
,2
Sunk costs - ✔✔are costs that have already been incurred and thus the money has already been
|| || || || || || || || || || || || || || || || ||
spent.
Opportunity costs - ✔✔are cash flows that could be realized from the next best alternative use of || || || || || || || || || || || || || || || || ||
an owned asset.
|| ||
this cost is not incremental - ✔✔sunk costs
|| || || || || || ||
these costs are relevant costs - ✔✔opportunity costs
|| || || || || || ||
Steps in Capital Budgeting Process: - ✔✔a. The cost of the new asset is the purchase price.
|| || || || || || || || || || || || || || || || ||
(Outflow)
b. Installation costs are any added costs necessary to get an asset into operation. (Outflow)
|| || || || || || || || || || || || || ||
c. Proceeds from sale of old asset are cash inflows resulting from the sale of an existing asset,
|| || || || || || || || || || || || || || || || || ||
reduced by any removal costs. (Inflow) || || || || ||
d. Tax on sale of old asset is incurred when the replaced asset is sold due to recaptured
|| || || || || || || || || || || || || || || || || ||
depreciation, capital gain, or capital loss. (May be an inflow or an outflow) || || || || || || || || || || || ||
e. The change in net working capital is the difference between the change in current assets and the
|| || || || || || || || || || || || || || || || || ||
change in current liabilities. (May be an inflow or an outflow)
|| || || || || || || || || ||
f. The book value of an asset is its strict accounting value.
|| || || || || || || || || || ||
what are key forms of taxable income - ✔✔gains and losses
|| || || || || || || || || ||
taxable income may arise from - ✔✔(1) capital gain: portion of sale price above initial purchase
|| || || || || || || || || || || || || || || ||
price, taxed at the ordinary rate; (2) recaptured depreciation: portion of sale price in excess of
|| || || || || || || || || || || || || || || ||
book value that represents a recovery of previously taken depreciation, taxed at the ordinary rate;
|| || || || || || || || || || || || || || ||
and (3) loss on the sale of an asset: amount by which sale price is less than book value, taxed at
|| || || || || || || || || || || || || || || || || || || || ||
the ordinary rate and deducted from ordinary income if the asset is depreciable and used in
|| || || || || || || || || || || || || || || ||
business.
, 2
The depreciable value of an asset is the - ✔✔installed cost of a new asset and is based on the
|| || || || || || || || || || || || || || || || || || || ||
depreciable cost of the new project, including installation cost. || || || || || || || ||
Depreciation is used to - ✔✔decrease the firm's total tax liability and then is added back to net
|| || || || || || || || || || || || || || || || || ||
profits after taxes to determine cash flow.
|| || || || || ||
To calculate incremental operating cash inflow for both the existing situation and the proposed
|| || || || || || || || || || || || || ||
project, - ✔✔the depreciation on assets is added back to the after-tax profits to get the cash flows
|| || || || || || || || || || || || || || || || || ||
associated with each alternative. || || ||
The terminal cash flow is - ✔✔is the cash flow resulting from termination and liquidation of a
|| || || || || || || || || || || || || || || || ||
project at the end of its economic life.
|| || || || || || ||
Terminal cash flow represents the - ✔✔the after-tax cash flows expected to result from the
|| || || || || || || || || || || || || || ||
liquidation of the project at the end of its life || || || || || || || || ||
The reason we don't include financing costs in the CF's estimations - ✔✔costs because they are
|| || || || || || || || || || || || || || || ||
used in the estimation of the PV of future CFs. Remember, the discount rate used to estimate PV
|| || || || || || || || || || || || || || || || || ||
(and in turn the NPV) is nothing but the cost of capital.
|| || || || || || || || || || ||
Risk-adjusted discount rates (RADRs) reflect the - ✔✔return that must be earned on a given || || || || || || || || || || || || || || ||
project in order to adequately compensate the firm's owners. The relationship between RADRs
|| || || || || || || || || || || || ||
and the capital asset pricing model (CAPM- capital asset pricing model) is a purely theoretical
|| || || || || || || || || || || || || || ||
concept
CAPM (capital asset pricing model) is not used for - ✔✔real assets
|| || || || || || || || || || ||
Investors themselves can more efficiently diversify their portfolio by holding a variety of -
|| || || || || || || || || || || || || ||
✔✔stocks
FINA 5320 Exam 2 with precise detailed || || || || || || ||
solutions
What is capital budgeting - ✔✔the process used to evaluate and select long-term investments
|| || || || || || || || || || || || || ||
consistent with the goal of owner wealth maximization. || || || || || || ||
what are captial expendirtures - ✔✔outlays made by the firm that are expected to produce
|| || || || || || || || || || || || || || ||
benefits over the long term (a period greater than one year). Not all capital expenditures are made
|| || || || || || || || || || || || || || || || ||
for fixed assets.
|| ||
conventional cash flow pattern - ✔✔consists of an initial outflow followed by a series of inflows
|| || || || || || || || || || || || || || ||
nonconventional cash flow pattern - ✔✔any pattern in which an initial outlay is not followed by a || || || || || || || || || || || || || || || || ||
series of inflows. || ||
The primary motives for making capital expenditures include: - ✔✔-Expansion—increasing the
|| || || || || || || || || || ||
productive capacity of the firm, usually through the acquisition of fixed assets.
|| || || || || || || || || || ||
• Replacement—replacing existing assets with new or more advanced assets that provide the same
|| || || || || || || || || || || || ||
function.
||
• Renewal—rebuilding or overhauling existing assets to improve efficiency.
|| || || || || || || ||
captial budgeting projects should be evaluated using - ✔✔incremental after tax cash flows
|| || || || || || || || || || || ||
The three components of cash flow for any project are - ✔✔(1) initial investment, (2) operating
|| || || || || || || || || || || || || || || ||
cash flows, and (3) terminal cash flows.
|| || || || || ||
Relevant cash flows - ✔✔any and all changes in the firm's future cash flows that are a direct
|| || || || || || || || || || || || || || || || || ||
consequence of taking the project || || || ||
,2
Sunk costs - ✔✔are costs that have already been incurred and thus the money has already been
|| || || || || || || || || || || || || || || || ||
spent.
Opportunity costs - ✔✔are cash flows that could be realized from the next best alternative use of || || || || || || || || || || || || || || || || ||
an owned asset.
|| ||
this cost is not incremental - ✔✔sunk costs
|| || || || || || ||
these costs are relevant costs - ✔✔opportunity costs
|| || || || || || ||
Steps in Capital Budgeting Process: - ✔✔a. The cost of the new asset is the purchase price.
|| || || || || || || || || || || || || || || || ||
(Outflow)
b. Installation costs are any added costs necessary to get an asset into operation. (Outflow)
|| || || || || || || || || || || || || ||
c. Proceeds from sale of old asset are cash inflows resulting from the sale of an existing asset,
|| || || || || || || || || || || || || || || || || ||
reduced by any removal costs. (Inflow) || || || || ||
d. Tax on sale of old asset is incurred when the replaced asset is sold due to recaptured
|| || || || || || || || || || || || || || || || || ||
depreciation, capital gain, or capital loss. (May be an inflow or an outflow) || || || || || || || || || || || ||
e. The change in net working capital is the difference between the change in current assets and the
|| || || || || || || || || || || || || || || || || ||
change in current liabilities. (May be an inflow or an outflow)
|| || || || || || || || || ||
f. The book value of an asset is its strict accounting value.
|| || || || || || || || || || ||
what are key forms of taxable income - ✔✔gains and losses
|| || || || || || || || || ||
taxable income may arise from - ✔✔(1) capital gain: portion of sale price above initial purchase
|| || || || || || || || || || || || || || || ||
price, taxed at the ordinary rate; (2) recaptured depreciation: portion of sale price in excess of
|| || || || || || || || || || || || || || || ||
book value that represents a recovery of previously taken depreciation, taxed at the ordinary rate;
|| || || || || || || || || || || || || || ||
and (3) loss on the sale of an asset: amount by which sale price is less than book value, taxed at
|| || || || || || || || || || || || || || || || || || || || ||
the ordinary rate and deducted from ordinary income if the asset is depreciable and used in
|| || || || || || || || || || || || || || || ||
business.
, 2
The depreciable value of an asset is the - ✔✔installed cost of a new asset and is based on the
|| || || || || || || || || || || || || || || || || || || ||
depreciable cost of the new project, including installation cost. || || || || || || || ||
Depreciation is used to - ✔✔decrease the firm's total tax liability and then is added back to net
|| || || || || || || || || || || || || || || || || ||
profits after taxes to determine cash flow.
|| || || || || ||
To calculate incremental operating cash inflow for both the existing situation and the proposed
|| || || || || || || || || || || || || ||
project, - ✔✔the depreciation on assets is added back to the after-tax profits to get the cash flows
|| || || || || || || || || || || || || || || || || ||
associated with each alternative. || || ||
The terminal cash flow is - ✔✔is the cash flow resulting from termination and liquidation of a
|| || || || || || || || || || || || || || || || ||
project at the end of its economic life.
|| || || || || || ||
Terminal cash flow represents the - ✔✔the after-tax cash flows expected to result from the
|| || || || || || || || || || || || || || ||
liquidation of the project at the end of its life || || || || || || || || ||
The reason we don't include financing costs in the CF's estimations - ✔✔costs because they are
|| || || || || || || || || || || || || || || ||
used in the estimation of the PV of future CFs. Remember, the discount rate used to estimate PV
|| || || || || || || || || || || || || || || || || ||
(and in turn the NPV) is nothing but the cost of capital.
|| || || || || || || || || || ||
Risk-adjusted discount rates (RADRs) reflect the - ✔✔return that must be earned on a given || || || || || || || || || || || || || || ||
project in order to adequately compensate the firm's owners. The relationship between RADRs
|| || || || || || || || || || || || ||
and the capital asset pricing model (CAPM- capital asset pricing model) is a purely theoretical
|| || || || || || || || || || || || || || ||
concept
CAPM (capital asset pricing model) is not used for - ✔✔real assets
|| || || || || || || || || || ||
Investors themselves can more efficiently diversify their portfolio by holding a variety of -
|| || || || || || || || || || || || || ||
✔✔stocks
