Corporate Finance

The Final Exam will be available on
Friday, December 9th, and will be due on Saturday, December 17th by midnight.

Once you open the exam, you have to complete the exam in 2.5 hours.
You have to complete the exam in one sitting.
The exam is an open book exam – pdf is attached.
Please note: You will have to show your calculations and / or provide an explanation for each question in order to get full credit.
Chapter 11 – Cash flow Estimation and Risk Analysis.

• Identify Relevant Cash Flows

1) Incremental Cash Flows = Corporate cash flow with the project – Corporate cash flow without the project.
 Those cash flows that arise solely from the asset that is being evaluated.

2) Cash Flow vs. Accounting Income
For capital budgeting purposes it is the project’s net cash flow, not its accounting income, which is relevant.

3) Interest Charges are Not Included in Project Cash Flows
• We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors.
• They are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs.

4) Sunk Costs  A cost that has already occurred and is not affected by the capital project decision. Sunk costs are not relevant to capital budgeting decisions.

5) Opportunity Costs Associated with Assets the Firm Already Owns  A cash flow that a firm must forgo in order to accept a project. For example, if the project requires the use of a building that could otherwise be rented, then the market rent value of the building is an opportunity cost of the project.

6) Externalities
a. Negative Within-Firm Externalities  Cannibalization, because the new business eats into the company’s existing business. The lost cash flows should be considered, and that means charging them as a cost when analyzing new products.

b. Positive Within-Firm Externalities  A new project can also be complementary to an old one, in which case cash flows in the old operation will be increased when the new one is introduced.

7) Inflation: Include inflation when estimating cash flows. Since the WACC includes the impact of inflation, the estimated cash flows must also include the impact of inflation.

Cash Flow Projections:

Intermediate Calculations:
• Estimate Net Operating Profit after Tax (NOPAT).

NOPAT = EBIT * (1 – Tax rate) 

EBIT = Revenue – Variable Costs – Non-Variable Costs – Depreciation

Revenue = Number of Units * Price per unit
Variable Costs = Number of Units * Cost per unit
Non-Variable Costs  Does not include depreciation

Note: Include inflation when estimating the revenue and costs. Since the WACC includes the impact of inflation, the estimated cash flows must also include the impact of inflation.

The depreciation expense for the year is = (Basis of Equipment * year’s depreciation rate).
Basis of Equipment = Cost + Shipping + Installation

• Net Operation Working Capital (NOWC)  Usually equal to a percentage of the upcoming year’s sales.

Adjustments to NOPAT
1) The first step is to add back depreciation, which is a noncash expense.
2) Adjust for Asset Purchases as a negative cash flow (usually at the beginning of the project).
3) Adjust for the Salvage value cash flow (usually at the end of project)
Cash flow from sale = Salvage Value – Taxes paid
Taxes paid = (Salvage Value – Book Value) * (Tax rate)
4) Adjust for Net Operating Working Capital  Subtract the change in NOWC.