Chp8_ReviewAnswers - 5 The financial manager’s goal is to...

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Chapter 8 Fundamentals of Capital Budgeting Answers to Chapter 8 Review Questions 1. The incremental earnings of a project comprise the amount by which the project is expected to change the firm’s earnings. Pro forma indicates that these earnings are estimated. 2. Pro forma incremental earnings comprise the amount by which the investment is expected to change the firm’s earnings, while pro forma free cash flows indicate the amount by which the investment is expected to change the firm’s free cash flows. 3. Net working capital is the net amount of current assets required to operate the investment. Net working capital is defined as Cash + Receivables + Inventory - Payables. 4. A project may expand the size of the firm, which may require increases in current assets. This increase in current assets requires the investment of cash to purchase these assets, which affects the cash flows of the firm. Because we are concerned about the incremental cash flows of the project, changes in net working capital are important in the analysis.
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Unformatted text preview: 5. The financial manager’s goal is to maximize the wealth of shareholders. Shareholders own the entire firm, thus managers must be aware of an investment’s effects on cash flows of the entire firm. Thus, if an investment in one division of the firm will affect another division’s cash flows, this externality must be considered in order to make the correct investment decision. 6. Accelerated depreciation generally increases the NPV of an investment relative to straight-line depreciation because it accelerates the tax savings from the depreciation of assets. 7. Sensitivity analysis is performed by measuring the NPV of an investment as you alter one of the assumptions of the NPV analysis (this could be the growth rate of sales, the discount rate, the expected tax rate, etc.). This allows you to observe the sensitivity of NPV to each assumption and identify the most “influential” assumptions in your NPV analysis....
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