Question

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 pain-

reliever 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

Answer 1

1) Accounting earnings may differ from the actual cash flow due to a number of reasons. For example, when a company sells something it records the sales as revenue and corresponding expenses are recorded which results in accounting earnings but the customer may or may not pay the money in the future. Also, accounting earnings are affected by non-cash expenses such as depreciation and amortization for which cash flow occurs at the beginning of the project.

Due to the above-mentioned reasons, the accounting earnings are not reliable and hence the after-tax free cash flow is used in estimating the NPV of the project.