CPA Exam (BEC B3) questions &
answers.
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.
answers.
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.
