BEC 3 - CPA Exam

Current assets - current liabilities = Working Capital

Relevant cash flows are those that we can keep after paying taxes

If a new asset acquisition requires the sale of old assets, the subsequent gain or loss has no effect on the capital expenditure decision because the book value of the old asset is a sunk cost (ignore sunk costs). The cash received from the sale of the old asset reduces the new investment's value. If a gain or loss (for tax purposes) exists, there is also a corresponding increase or decrease in income taxes. The amount of income tax paid on a gain on a sale is treated as a reduction of the sales price (which increases the initial expenditure). Conversely, a reduction in tax resulting from a loss on sale is treated as a reduction of the new investment.

-Net proceeds on sale of old asset offset cost of new, this initial outflow decreases

-When new asset is eventually sold, net proceeds on sale - one time future cash inflow.

DCF valuation methods include:
-Net Present value method
- Internal Rate of Return

These techniques use the time value of money concepts to measure cash inflows and cash outflows of a project as if they occurred at a single point in time. DCF methods are considered the best methods to use for valuation of assets and liabilities that are realized over long periods of time.

The rate used to discount future cash flows is set by management using any number of different approaches:
1) Mgmt may use a WACC method
2) Mgmt may simply assign a target for new projects
3) Mgmt may recommend that the discount rate be related to the risk specific to the proposed project.

Step 1: Calculate after-tax cash flows
Annual net cash flow x (1-tax rate)
Step 2: Add depreciation benefit = Depreciation x tax rate
Step 3: Multiply result by appropriate present value of an annuity
Step 4: Subtract initial cash outflow
Result: Net Present value

Discounted cash flow methods use a simple constant growth (single interest rate) assumption. This assumption is often unrealistic because, over time, as management evaluates its alternatives, actual interest rates or risks may fluctuate.

The payback period method measures the time it will take to recover the initial investment (measuring liquidity).

The payback period method is often used for risky investments.

Payback period = Net initial investment
Increase in annual net after-tax cash flow

Advantages:
-Easy to understand
-Emphasis on Liquidity

Limitations:
-Time value of money is ignored
-Project cash flows occurring after the initial investment is recovered are not considered.
-Reinvestment of CF is not considered
-Total project profitability is neglected

Focus decision makers on the initial investment amount that is required to purchase (or invest) in a capital asset that will yield returns in an amount excess of a management designed hurdle rate.

NPV requires managers to evaluate the dollar amount of the return (EVA)

IRR - percentages of return

Payback method - years to recover principle

The hurdle (target) rate is the desired (or minimum) rate of return that is set by management to evaluate investments.

Different rates may be used for different time periods using the NPV method.

The NPV method is considered to be superior to the IRR method because it is flexible enough to consistently handle either uneven cash flows or inconsistent rates of return for each year of the project.

Advantages:
-Very flexible and can be used when there is no constant rate of return required each year of the project

Limitations:
-Does not provide the true rate of return on the investment. The NPV purely indicates whether or not an investment will earn the "hurdle rate" used in the NPV calculation.