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Unformatted text preview: CHAPTER 7 ANSWERS 7-1 Only cash can be spent or reinvested, and because accounting profits do not represent cash, they are of less fundamental importance than cash flows for investment analysis. Recall that in the stock valuation chapter we focused on dividends, which represent cash flows, rather than on earnings per share. 7-2 a. The firm has depreciated the asset to a book value less than its salvage value (book value is $0); that is, the firm has taken excess depreciation. Thus, the firm must declare this excess as income and pay ordinary taxes on it. This is called recapture of depreciation . b. The change in depreciation simply is the difference between the depreciation associated with the existing asset and the depreciation associated with the new (replacement) asset. The relevant depreciation is the incremental depreciation shown in Section II. c. A reduction in net working capital would lead to a reduction in net investment. Note that net working capital would then increase at the end of the projects life and this increase would be shown as a cash outflow for that year. d. The cost savings associated with the new machine will result in less cash outflow each year, less operating expenses, and greater taxable income. Less cash will be spent for operating expenses, so the cost savings represent a cash inflow, or a positive amount, when compared to the existing asset. 7-3 Capital budgeting analysis should only include those cash flows that will be affected by the decision. Sunk costs are unrecoverable and cannot be changed, so they have no bearing on the capital budgeting decision. Opportunity costs represent the cash flows the firm gives up by investing in this project rather than its next best alternative, and externalities are the cash flows (both positive and negative) to other projects that result from the firm taking on this project. These cash flows occur only because the firm took on the capital budgeting project; therefore, they must be included in the analysis. 7-4 When a firm takes on a new capital budgeting project, it typically must increase (decrease) its investment in receivables and inventories, over and above the increase (decrease) in payables and accruals, thus increasing (decreasing) its net working capital. Because this increase (decrease) must be financed, it is included as an outflow (inflow) in Year 0 of the analysis. At the end of the projects life, we assume the firm is returned to its original condition, thus inventories and receivables are restored to their original levels. Therefore, there is a decrease (decrease) in NWC, which is treated as an inflow (outflow) in the final year of the projects life. 7-5 Recognition of incremental cash flows is more important in replacement analysis. In a new project, all cash flows must be implicitly recognized, but in a replacement analysis only those cash flows that change due to the replacement are considered. Incremental cash flows are the correct ones to analyze because we are trying to determine if they are sufficient to...
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