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CPA Exam (BEC B3) (1
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CPA Exam (BEC B3)Cash Flows Related to Capital Budgeting - ANS-Relevant ones are always after-tax. Cap
budgeting is used to evaluate/select LT investmt projects that add value. Amt of cash
inflows/outflows for investmts affects amt of cash available for ops, etc. Type of CF effects:
-direct effect: when co pays cash, gets cash, or makes a cash committment directly related to
cap investmt. Immediate effect on cash available. Direct CFs.
-indirect effect: transactions indirectly assoc. w/ cap project or that rep noncash activity
producing cash benefits/obligations. Net proceeds on sale of old reduces cost of new. Depr is
largest indirect effect bc govt tax deduction. Depr x TR = $ saved.
-net effect: total of direct and indirect effects.
Stages of Cash Flows - ANS-CFs exist throughout life cycle of cap investmt project. 3 stages.
1. Inception of the project:
Time pd 0. Today's cost = initial outflow. Usually largest outflow. Includes direct CF effects (acq
cost of asset) and indirect (WC rqmts and disposal of replaced asset).
-WC: CA-CL. May need to incr/decr to ensure success of project. Additional WC rqmts come
from "buying" WC, outflow. Increases in payroll, supplies exp, inv rqmts. Reduced WC rqmts
come from "selling" WC, inflow. Implementing JIT inv system.
-Disposal of replaced asset:
(1) If replaced asset is abandoned, net SV reduces initial investmt in new asset. Offsets cost of
new (SP-NBV = G/L). The BV of the abandoned asset is a sunk cost, so irrelevant to decision
making. Remaining BV deductible as a loss for taxes, which reduces initial investmt in new
asset.
(2) If old asset sold, cash received from sale of old reduces new investmt value. If G/L, taxes on
G incr investmt, deduction on L reduces new investmt. SP (inflow) - [gain x tr] (outflow) + [loss x
tr] (inflow) = net proceeds on sale of old.
So Step 1: Net initial cost (invoice, ship, install, training) outflow + incr in WC outflow - net
proceeds on sale of old inflow = net outflow.
2. Operations:
Future annual OCF = inflow. Ongoing ops of project will affect direct/indirect CFs. Direct are CFs
from ops of asset on reg basis. Could be annuity or diff each yr. Indirect is depr tax shields.
So Step 2: [pretax CF x (1-tr)] + [depr x tr] = annual OCF.
3. Disposal of the Project:
One-time TYCF = inflow. Disposal of investmt at end of project produces direct/indirect CFs.
-If sold, direct inflow on sale and indirect for taxes due/ saved for G/L. Always net of tax so (SP -
BV = G/L - tax if G = net).
,-Could be direct exp on disposal like severance pay (outflow).
-Indirect effect could be tax savings from scra
Calculation of Pretax and After-Tax Cash Flows - ANS-Pretax: Comp of asset's value is based
on CFs it generates. Investmt value based on PV FCFs. If outflows > inflows, unprofitable
project. Purpose of investmt is sales incr and/or exp decr.
After-tax: Relevant. Computation:
-estimate net cash inflows (inflows - outflows)
-subtract noncash tax deductible expenses to get TI
-compute IT for each yr of project's useful life
-subtract tax exp from net cash inflows to get AT CFs.
-OR *[pretax CF x (1-tr)] + [depr x tr]* to get AT CFs (annual OCF).
Op CFs may differ from NI. All taxes on I/S may not be applicable to CY. Actual taxes paid may
exceed I/S estimate. Amt of $ saved from depreciation deduction is increased if depreciation
expense increases from MACRs or if the TR increases. MACRS depr > SL. Changes in WC rep
a source or use of cash, but aren't taxed.
Discounted Cash Flow - ANS-If sum of PCFCF > today's costs, profit. Accept. Otherwise, no.
Types of DCF methods are NPV and IRR. These use the time value of money to measure the
PV of FCFs from a project.
The rate of return desired for the project is set by mgmt. Should comp for all risk assumed. Also
called hurdle rate and discount rate. Ways to set:
-WACC
-mgmt target
-discount rate based on risk specific to the project. If risk similar to other projects of co, WACC
approp bc it reflects the mkt's assessmnt of the avg risk of cos projects.
Limitation of DCF is the simple constant growth assumption. Use single interest rate
assumption, assume growth will happen at that rate. Unrealistic bc actual int rates/risks may
fluctuate. NPV allows for r to change, IRR doesn't.
Net Present Value Method (NPV) - ANS-DCF method used to screen cap projects for
implementation. Focus decision makers on initial investmt amt to purch cap asset that will yield
returns greater than the hurdle rate. Better bc focuses on dollars like investors want. Mgmt must
evaluate the dollar amt (EVA) of return rather than %s or yrs to recover principal.
In calcing NPV, use 3 steps in stages of CFs.
a. Est direct/indirect CFs related to investmt:
-ignore depr unless it's a tax shield. MACRS instead of straight line incr PV of tax shield.
, -ignore method of funding. NPV uses hurdle rate (WACC, etc.) to discount CFs. Method of
financing and related costs independent of process of screening investmts under NPV.
b. Discount CFs to PV using approp discount factor based on hurdle rate and timing of CF. NPV
assumes CFs are reinvested at same rate used in the analysis. IRR assumes CFs reinvested at
IRR.
c. Compare PV inflows and outflows.
So basically:
-calc AT CFs (annual net CF x (1-tr))
-add depr benefit (depr x tr)
-Multiply sum by approp PV factor
-Subtract intial cash outflow= NPV.
If result is positive, make investmt. Profit. Sum of PVFCF> cost. EVA. Infer IRR > hurdle rate. If
unlimited funds, all projects w/ NPV>0 S/B accepted. If limited funds, rank projects and accept in
order.
If result is neg, don't make investmt. Loss. Sum PVFCF< cost. Value decr. Infer IRR < hurdle
rate.
If NPV = 0, IRR = hurdle rate. Mgmt indifferent.
Interest Rate Adjustments for Required Return - ANS-Advantage for NPV- yes! NPV can incorp
many types of hurdle rates (WACC, int rate of opp cost, or other min required rate of return).
Rates can be modified to adjust for:
1. Risk: incr discount rate to factor in more risk. Rate incr, risk incr, PVFCF decr.
2. Inflaton: loss of purch power so risk incr. Raise rates to compensate for expected inflation. If
mgmt anticipates no change in TRs, cash flows from effects of depr wouldn't be adj for inflation
bc they relate to original investmt.
Major advantage of NPV over IRR is that diff rates can be used for diff time pds under NPV.
NPV is considered to be superior bc it's flexible enough to consistently handle either uneven
CFs or inconsistent rates of return for each yr of the project. IRR limited to single discount rate.
Projects that meet qualitative mgmt criteria (mandated tech investmts) are only subj to financing
considerations, not cap budgeting. Discount rate for NPV here would be AT cost of borrowing
(incremental borrowing rate).
Advantages and Limitations of the Net Present Value Method - ANS-Advantages: flexible, can
be used when there's no constant rate of return req for each yr of project.
Limitations: doesn't provide true rate of return on investmt. Only says if it'll earn the hurdle rate
used in the NPV calc.
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