Cash Flow Analysis

1) Which of the following is INCORRECT in determining free cash flows? Adjust net income for interest expense This is NOT the correct answer because it is true; you do adjust net income for interest expense in determining free cash flows. Subtract capital expenditures This is NOT the correct answer because it is true; you do subtract capital expenditures in determining free cash flows. Subtract depreciation correct This is the correct answer! It is NOT true. You ADD BACK depreciation in determining free cash flows. Subtract change in working capital This is NOT the correct answer because it is true; you do subtract the change in net working capital in determining free cash flows. 2) A project has an initial cost of $44,000. Expected cash flows as a result of this project are projected as indicated below. Calculate the payback period for this project. Assume a discount rate of 9%. The correct answer is 3.5 years. At the end of year 3 the project has returned $35,000 ($10,000 + $10,000 + $15,000). This leaves $9,000 to be returned to hit payback. Assuming that the $18,000 projected for year 4 comes in a steady stream, this would mean it would take half of that year. =3+(44000-(B4+B5+B6))/18000 3) The founders of a business are interested in investing in a project in the coming year. The two projects are mutually exclusive. The estimated cash flows of the two projects are shown below. The company's Weighted Average Cost of Capital (WACC) is 9%. The table below shows the data from the previous spreadsheet exercise and the correct IRR calculation. t 0 1 2 3 4 5 6 7 PROJECT 1 Cash Flows ($300,000) $30,000 $45,000 $60,000 $60,000 $60,000 $60,000 $120,000 IRR: 8.55% t 0 1 2 3 4 5 6 7 PROJECT 2 Cash Flows ($120,000) $40,000 $40,000 $25,000 $20,000 $10,000 $10,000 $10,000 IRR: 9.60% Which project should the company undertake? Project 1 Project 2 correct The correct answer is Project 2. Project 2 has the higher IRR and the IRR for Project 1 is below the WACC of 9%. 4) What is free cash flow? It is “free” money, which means it is available at a 0% interest rate. It is the amount of cash that a business could be expected to generate from its normal operations. correct Free Cash Flow is another name for Net Income. It is the total amount of money being transferred into and out of a business. Free cash flow is the amount of cash that a business could be expected to generate from its normal operations. 5) Which of the following cash flows should be used in an NPV calculation to determine which project to pursue? (Select all that apply.) The cash inflows expected as a result of the project correct This is correct! It is an incremental cash flow that would only be received if the project were undertaken. Recurring cash flows from ongoing current operations This is not a relevant cash flow because it would be recurring regardless of which project is pursued. Investment needed to be made by the company to undertake the project correct This is correct! It is an incremental cash flow that would only be incurred if the project is undertaken. Capital expenditures related to upkeep of existing equipment This is not a relevant cash flow because it would be incurred regardless of which project is pursued. 6) A CFO of a start-up company is evaluating the timing of a significant capital expenditure. He was previously at a mature company that used a discount rate of 8% so he used the same rate at the start-up company. Which of the following would be impacted if the discount rate were raised to reflect the risk of the startup company? Internal rate of return This would not be impacted by a change in the discount rate. Payback period This would not be impacted by a change in the discount rate. Return on investment This would not be impacted by a change in the discount rate. Net present value correct NPV is the only one of the answer choices that is impacted by the discount rate. 7) A project has the estimated cash flows shown as indicated below. The discount rate is 8% and the NPV is $17,924. Calculate the IRR of this project. The correct answer is 18.97%. The correct answer formula, which should be entered into cell E6, is the following: =IRR(B2:B7) 8) Which of the following statements is NOT true in relation to the Gordon Growth Model? Terminal value is the present value of infinite cash flows expected in the future. This statement is true. A higher discount rate results in a higher terminal value. correct This statement is not true. A higher discount rate results in a lower terminal value. The Gordon Growth Model assumes that the growth rate will remain fixed. This statement is true. A higher growth rate results in a higher terminal value. This statement is true. 9) When projecting financial statements, which of the following accounts is difficult to forecast using the percent of sales method? Accounts Receivable Accounts Receivable will normally trend with sales. Accounts Payable Accounts Payable will normally trend with sales. Interest Expense correct Normally, Accounts Receivable, Accounts Payable, and Cost of Sales will trend in a direct relationship with sales. However, Interest Expense is more dependent upon the level of borrowings which does not necessarily track with sales. Cost of Sales Cost of Sales will normally trend with sales. 10) A company is considering buying a diagnostic piece of equipment for $250,000. The machine will be depreciated on a straight-line basis for 10 years with a salvage value of $40,000. The company expects the machine to be able to generate after-tax revenues of $33,000 in each of the 10 years, and then it will sell the machine for $40,000 at the end of 10 years. The sum of the undiscounted cash flows is $370,000. The discount rate is 7%. The net present value is calculated to be $2,112. Which of the following statements is true? The company should not buy the equipment because the NPV is less than the annual revenues expected. The fact that the NPV is less than the annual revenues is not relevant and leads to an incorrect conclusion not to purchase the equipment. The company should not buy the equipment because the NPV is less than the initial cost of the equipment. The fact that the NPV is less than initial cost of the equipment is not relevant and leads to an incorrect conclusion not to purchase the equipment. The company should buy the equipment because the sum of the undiscounted cash flows is greater than the initial cost of the equipment. The fact that the sum of the undiscounted cash flows exceeds the purchase price is true, but it does not consider the time value of money and therefore is not a reason to purchase the equipment. The company should buy the equipment because the NPV is positive. correct As long as the NPV is positive, even if it is a very small positive number, it means the company will earn a return greater than its discount rate, so it is a good investment. 11) Cybertrex, a manufacturing facility, rented a new piece of equipment on January 1st and agreed to pay an annual rental fee of $18,000 at the end of each of the next 10 years. The weighted average cost of capital of the company is 8%. The present value of $1 for 10 years at 8% is 0.46319 The present value of an ordinary annuity of $1 for 10 years at 8% is 6.71008 What is the Present Value of the rental payments over 10 years? $180,000 $55,945 $8,337 $120,781 correct The correct answer is: $120,781 It is calculated by multiplying the annual payment by the present value of an annuity factor. $18,000 * 6.71008 = $120,781 12) An automotive parts company that sells to automotive manufacturers is forecasting revenue as part of its internal budgeting and planning process. Which of the following is LEAST likely to be important in its forecasting assumptions? Expected number of customers This would likely impact the revenue forecast. Customer acquisition and retention rates This would likely impact the revenue forecast. Profitability of customer orders This would likely impact the revenue forecast. Level of long-term debt correct The level of long-term debt would not likely impact the revenue forecast. 13) On which financial statements would you be most likely to find information about capital expenditures related to the purchase of equipment during the past year? Look at the ending balance of the PPE account in the balance sheet Look for a large decrease in cash or large increase in accounts payable on the balance sheet Look for a change in the depreciation expense on the income statement Look at the investing section in the statement of cash flows Correct The correct answer is to look at the investing section in the statement of cash flows. The other alternatives would only give partial, and possibly misleading, information about capital expenditures. The investing section of the statement of cash flows would directly show the cash spent on capital purchases. 14) Which of the following options is true in regards to financial forecasts? Forecasts are calculated based on historical data figures so they are extremely accurate. Forecasting involves a high level of subjectivity and assumption making, so they are inherently inaccurate. All cash flows will increase or decrease proportionately to forecasted sales numbers. While some cash flows will move in relationship to sales, such as variable costs and current asset cash flows, not all cash flows do. Accounts like capital investments and income tax expense will not vary directly with sales. Forecasts are exclusively used internally by management on a company level for general budgeting purposes. Forecasts are regularly used by both internal management and external parties. Internally they can be used on the company level as above, but also on a project or department level. Further, forecasts are very important to outside individuals looking to invest as well as outside institutions involved in any financing with the company. Odds are, forecasts will differ from actual results. correct Because of the assumptions that need to be made when creating forecasts and the subjectivity involved in making those assumptions, a financial forecast may be good base idea of the company's future operations, but they will most likely not be exactly correct. 15) Company A estimates that it needs 30% of sales in net working capital. In year 1, sales were $1 million and in year 2, sales were $2 million. Associated with the change in net working capital from year 1 to year 2 is a cash: inflow of $300,000. outflow of $300,000. correct inflow of $600,000. outflow of $600,000. The correct answer is an outflow of $300,000. The company would need to make a cash investment (outflow) of $300,000 to increase their net working capital from the $300,000 needed to support $1 million of sales to the $600,000 needed to support $2 million of sales. 16) Applied Medical Services buys a diagnostic piece of equipment for $326,000. The machine will be depreciated on a straight-line basis for 10 years with a salvage value of $75,000. The company expects the machine to be able to generate aftertax cash flows of $64,000 in each of the 10 years, and then it will sell the machine for $75,000 at the end of 10 years. What are the cash flows related to this purchase for each of the next 10 years? Ignore taxes. Note: Enter numerical values ONLY. Do not enter text such as dollar signs, commas, or parentheses. As is the case in Excel, to indicate a negative number, please use the "-" negative symbol rather than parentheses. he annual cash flows will commence at the beginning of year 1 when the piece of equipment is purchased. This will be a negative cash flow of $326,000. In the next 9 years, the company will benefit from the $64,000 of after-tax cash flow generated each year. In year 10 the company will also benefit from the salvage value of $75,000 bringing that year's cash flow to $139,000. t 0 1 2 3 4 5 6 7 8 9 10 Cash Flow -326,000 64,000 64,000 64,000 64,000 64,000 64,000 64,000 64,000 64,000 139,000 17) Clean Air Systems buys a diagnostic piece of equipment for $270,000. The machine will be depreciated on a straight-line basis for 10 years with a salvage value of $50,000. The company expects the machine to be able to generate after- tax cash flows of $43,000 in each of the 10 years, and then it will sell the machine for $50,000 at the end of 10 years. The discount rate is 7%. What is the Net Present Value? The correct answer is $57,431. The correct answer formula, which should be entered into cell E5, is the following: =NPV(E4,B3:B12)+B2 Remember, for NPV you have to manually add the negative outflow from time zero related to the initial investment. 18) A company has retained earnings of $94,000 as of December 31, 2014. The Proforma income statement projects net income of $22,000 for 2015. The company expects to declare their annual dividend on March 15, 2015 of $0.70 per share and has a total of 100,000 shares outstanding. What will the projected retained earnings account be as of December 31, 2015? $186,000 $46,000 correct $16,000 $2,000 To calculate the projected retained earnings, you add the projected 2015 net income of $22,000 to the beginning balance of $94,000 carried over from 2014. Then you must subtract $70,000 for the dividend of $0.70 per share times the 100,000 shares outstanding. $94,000 + $22,000 - $70,000 = $46,000