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Unformatted text preview: CHAPTER 10 CAPITAL BUDGETING AND CASH FLOW ANALYSIS ANSWERS TO END OF CHAPTER QUESTIONS: 1. A capital expenditure is a cash outlay that is expected to generate a flow of future benefits lasting longer than one year. Examples of capital expenditures include purchase of machinery to manufacture a product, renovation of a plant, construction or purchase of a new headquarters building, and acquisition of an existing business. 2. Incremental cash flow refers to the difference in cash flows experienced by the firm as a result of adopting a project compared to not adopting the project. 3. In capital expenditure analysis opportunity cost of resources (assets) refers to the cash flows those resources could generate if they are not used in the project under consideration. 4. The factors that should be considered when estimating a project's net investment include the new project cost plus shipping and installation charges and required increases in working capital at project inception. In the case of an asset replacement decision, in addition, the net proceeds from the sale of the old asset and the taxes associated with the sale of the old asset must also be considered. 5. Depreciation is considered only in so far as its impact on taxes is concerned. 6. If the old asset is sold for its book value there are no tax consequences. If the asset is sold for less than book value, the difference may be charged as a loss against ordinary income thereby generating a tax credit (i.e., savings). If the asset is sold for more than book value but less than original cost, the difference is treated as ordinary income and taxed at the ordinary tax rate. If an asset is sold for more than original cost, the difference between book value and original cost is taxed as ordinary income and the difference between the sale price of the asset and its original cost is taxed as a capital gain. Under current tax laws the tax rate on capital gains is the same as the tax rate on ordinary income for most large U.S. corporations. 7. In the case of a replacement project the relevant measure of net cash flows is the incremental difference in the cash flows with the replacement project and the cash flows assuming the firm keeps the current (or old) asset . In other words, net cash flows must be estimated twiceonce with the replacement project and once without the replacement project. In the case of a new business project on the other hand only one set of statements with the new project is needed. 8. In addition to investments in fixed assets that are normally part of any capital expenditure project, firms also have to invest in current assets such as accounts receivable and inventory to support a business. Investments in net working capital involve a commitment of funds just as investments in fixed assets do consequently they should be considered in estimating capital budgeting cash flows. The initial increase in net working capital should be shown in the net investment calculations. Additional...
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- Spring '08