Practice_Problems_5_Capital_Budgeting - FIN340 PRACTICE...

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1 FIN340 PRACTICE PROBLEM SET 5 CAPITAL BUDGETING Frequently Asked (Shorter) Questions: 1. In the context of capital budgeting, what is an opportunity cost? An opportunity cost is the most valuable alternative that is foregone if a particular project is undertaken. The relevant opportunity cost is what the asset or input is actually worth today, not, for example what it cost to acquire (e.g., the historical cost on the balance sheet). 2. Given a choice, would a firm prefer to use MACRS (Modified Accelerated Cost Recovery System) depreciation or straight-line depreciation? Why? For tax purposes, a firm would choose MACRS because it allows for larger (“accelerated”) depreciation deductions earlier. These larger deductions reduce taxes early in the life of the project, but have no other cash consequences. Notice that the choice between MACRS and straight-line is an issue of minimizing the time value of corporate taxes. The total depreciation is the same, only the timing of tax payments differs. The increased depreciation early in the project’s life increases its (after-tax) NPV and hence its likelihood of acceptance. 3. In our capital budgeting examples, we assumed that a firm would recover all of the working capital it invested in a project. Is this a reasonable assumption? When might it not be valid? It’s only a mild over-simplification. Current liabilities will all be paid presumably. The cash portion of current assets will be retrieved. Some receivables won’t be collected, and some inventory will not be sold, of course. Counterbalancing these losses is the fact that inventory of final products is sold above cost (and not replaced at the end of the projects life), which thus acts to increase working capital. These effects tend to roughly offset each other. 4. Suppose a financial manager is quoted as saying, “Our firm uses the stand-alone principle to determine the incremental project cash flow because we treat projects like mini-firms in our project evaluation process. Among other things, we include financing costs in this process because they are relevant at the firm level.” Critically evaluate this statement. Management’s discretion to set the firm’s capital structure is applicable at the firm level and we’ll discuss this in detail later in the course. Since any one particular project could be financed entirely with equity, another project could be financed entirely with debt, and the firm’s overall capital structure remains unchanged. Therefore, financing costs are irrelevant in the analysis of a project’s incremental cash flows according to the stand-alone principle
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2 5. When is EAC (Equivalent Annual Cost) analysis appropriate for comparing two or more projects? Why is this method used? Are there any implicit assumptions required by this method that you find troubling? Explain.
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Practice_Problems_5_Capital_Budgeting - FIN340 PRACTICE...

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