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Unformatted text preview: Q9-1.In capital budgeting analysis, why do we focus on cash flowrather than accounting profit?A9-1.Accounting numbers may not accurately reflect when revenues are received or when payments are made. Net present value focuses on when money is actually received or paid and then discounts these cash flows at an appropriate rate to find whether a project adds value to a company. This emphasis recognizes that whatever accounting earnings a company has, it must generate sufficient cash to pay its bills or it will not stay in business very long.Q9-6.What are the tax consequences of selling an investment asset for more than its book value? Does this have an effect on project cash flows that must be accounted for in relevant cash flows? What is the effect if the asset is sold for less than its book value?A9-6.If an investment is sold for more than its book value, then the firm has a capital gain on the difference between market price and book value and must pay capital gains taxes on that difference. The relevant cash flows are the market price of the investment sale minus the additional taxes. If an asset is sold for less than book value, then the company can claim a tax credit on the difference between the market price and the book value. This credit is the difference between market value and book value times the tax rate. The relevant cash flows are the market price of the asset plus the tax credit. Q9-12.What is the only relevant decision for independent projects if an unlimited capital budget exists? How does your response change if the projects are mutually exclusive? How does your response change if the firm faces capital rationing?A9-12.If the capital budget is unlimited, managers should rank the available projects according to their PIs and invest in all projects with a PI > 1, respectively all projects with a NPV >0. If the projects are mutually exclusive though, managers should chose the one with the highest NPV, since the ranking according to PI and NPV may differ due to the scale of the projects , and invest in it if there is sufficient capital. If the company faces capital rationing, it should invest in the projects based on its PI ranking. Q9-14.Why isnt excess capacity free?A9-14.Excess capacity is not free. It was originally accounted for when the project was first chosen that size equipment that produced the excess capacity was included in those project cash flows. If there truly is no use for excess capacity, now or in the future, for the original project, then a new project could use that excess capacity at no additional charge to the project. However, if using excess capacity for a new project means that the original project will have to add more capacity at some time in the future, this should be charged to the new project....
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This note was uploaded on 03/21/2011 for the course FI 360 taught by Professor Tavbin during the Spring '08 term at Park.
- Spring '08
- Net Present Value