FIN 300 CHAPTER 8 EXAM #2
QUESTIONS AND ANSWERS
Given the choice, would a firm prefer to use MACRS depreciation or straight-line
depreciation? Why? - ANSWER-For tax purposes, a firm would choose MACRS
because it provides for larger depreciation deductions earlier. These larger
deductions reduce taxes, but have no other cash consequences. Notice that the
choice between MACRS and straight-line is purely a time value issue; the total
depreciation is the
same, only the timing differs.
In our capital budgeting examples, we assumed that a firm would recover all of
the working capital it invested in a project. Is this a reasonable assumption? When
might it not be valid? - ANSWER-It's probably only a mild over-simplification. Current
liabilities will all be paid presumably. The cash portion of current assets will be
retrieved. Some receivables won't be collected, and some inventory will not be sold,
of course. Counterbalancing these losses is the fact that inventory sold above cost
(and not replaced at the end of the project's life) acts to increase working capital.
These effects tend to offset.
Suppose a financial manager is quoted as saying, "Our firm uses the standalone
principle. Because we treat projects like minifirms in our evaluation process, we
include financing costs because they are relevant at the firm level." Critically
evaluate this statement. - ANSWER-Management's discretion to set the firm's capital
structure is applicable at the firm level. Since any one particular project could be
financed entirely with equity, another project could be financed with debt, and the
firm's overall capital structure remain unchanged, financing costs are not relevant in
the analysis of a project's incremental cash flows according to the stand-alone
principle.
What is the essential difference between sensitivity analysis and scenario analysis? -
ANSWER-With a sensitivity analysis, one variable is examined over a broad range of
values. With a scenario
analysis, all variables are examined for a limited range of values.
A co-worker claims that looking at all this marginal this and incremental that is just a
bunch of nonsense and states: "Listen, if our average revenue doesn't exceed our
average cost, then we will have a negative cash flow, and we will go broke!" How do
you respond? - ANSWER-It is true that if average revenue is less than average cost,
the firm is losing money. This much of the
statement is therefore correct. At the margin, however, accepting a project with
marginal revenue in
excess of its marginal cost clearly acts to increase operating cash flow. At the
margin, even if a firm
QUESTIONS AND ANSWERS
Given the choice, would a firm prefer to use MACRS depreciation or straight-line
depreciation? Why? - ANSWER-For tax purposes, a firm would choose MACRS
because it provides for larger depreciation deductions earlier. These larger
deductions reduce taxes, but have no other cash consequences. Notice that the
choice between MACRS and straight-line is purely a time value issue; the total
depreciation is the
same, only the timing differs.
In our capital budgeting examples, we assumed that a firm would recover all of
the working capital it invested in a project. Is this a reasonable assumption? When
might it not be valid? - ANSWER-It's probably only a mild over-simplification. Current
liabilities will all be paid presumably. The cash portion of current assets will be
retrieved. Some receivables won't be collected, and some inventory will not be sold,
of course. Counterbalancing these losses is the fact that inventory sold above cost
(and not replaced at the end of the project's life) acts to increase working capital.
These effects tend to offset.
Suppose a financial manager is quoted as saying, "Our firm uses the standalone
principle. Because we treat projects like minifirms in our evaluation process, we
include financing costs because they are relevant at the firm level." Critically
evaluate this statement. - ANSWER-Management's discretion to set the firm's capital
structure is applicable at the firm level. Since any one particular project could be
financed entirely with equity, another project could be financed with debt, and the
firm's overall capital structure remain unchanged, financing costs are not relevant in
the analysis of a project's incremental cash flows according to the stand-alone
principle.
What is the essential difference between sensitivity analysis and scenario analysis? -
ANSWER-With a sensitivity analysis, one variable is examined over a broad range of
values. With a scenario
analysis, all variables are examined for a limited range of values.
A co-worker claims that looking at all this marginal this and incremental that is just a
bunch of nonsense and states: "Listen, if our average revenue doesn't exceed our
average cost, then we will have a negative cash flow, and we will go broke!" How do
you respond? - ANSWER-It is true that if average revenue is less than average cost,
the firm is losing money. This much of the
statement is therefore correct. At the margin, however, accepting a project with
marginal revenue in
excess of its marginal cost clearly acts to increase operating cash flow. At the
margin, even if a firm
