Chapter 10 Homework solutions

Chapter 10 Homework solutions - CHAPTER 10 Cash Flows and...

Info iconThis preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting ANSWERS TO END-OF-CHAPTER QUESTIONS 10-1. We focus on cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest. Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost. Also, we are only interested in these cash flows on an after tax basis as only those flows are available to the shareholder. In addition, it is only the incremental cash flows that interest us, because, looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project and, as such, are the increased value to the firm from accepting the project. 10-2. Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the project's life because of its effect on taxes. Depreciation is an expense item and, the more depreciation incurred, the larger are expenses. Thus, accounting profits become lower and, in turn, so do taxes, which are a cash flow item. 10-3. If a project requires an increased investment in working capital, the amount of this investment should be considered as part of the initial outlay associated with the project's acceptance. Since this investment in working capital is never "consumed," an offsetting inflow of the same size as the working capital's initial outlay will occur at the termination of the project corresponding to the recapture of this working capital. In effect, only the time value of money associated with the working capital investment is lost. 10-4. When evaluating a capital budgeting proposal, sunk costs are ignored. We are interested in only the incremental after-tax cash flows to the company as a whole. Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows. Hence, they are irrelevant. 10-5. Mutually exclusive projects involve two or more projects where the acceptance of one project will necessarily mean the rejection
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
of the other project. This usually occurs when the set of projects perform essentially the same task. Relating this to our discounted cash flow criteria, it means that not all projects with positive NPV's, profitability indexes greater than 1.0 and IRRs greater than the required rate of return will be accepted. Moreover, since our discounted cash flow criteria do not always yield the same ranking of projects, one criterion may indicate that the mutually exclusive project A should be accepted, while another criterion may indicate that the mutually exclusive project B should be accepted. 10-6. There are three principal reasons for imposing a capital rationing constraint. First, the management may feel that market conditions are temporarily adverse. In the early- and mid-seventies, this reason was fairly common, because interest rates were at an all-time high and stock prices were at a depressed level. The second reason is a manpower shortage, that is, a shortage of
Background image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

This note was uploaded on 02/20/2010 for the course FIN 565 taught by Professor Libnitz during the Spring '10 term at Academy of Design Tampa.

Page1 / 10

Chapter 10 Homework solutions - CHAPTER 10 Cash Flows and...

This preview shows document pages 1 - 3. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online