Chapter 10 Homework Solution
CHAPTER 10
Cash Flows and Other Topics
in Capital Budgeting
ANSWERS TO
END-OF-CHAPTER QUESTIONS
10-1. We focus on cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest. Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost. Also, we are only interested in these cash flows on an after tax basis as only those flows are available to the shareholder. In addition, it is only the incremental cash flows that interest us, because, looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project and, as such, are the increased value to the firm from accepting the project.
10-2. Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the project 's life because of its effect on taxes. Depreciation is an expense item and, the more depreciation incurred, the larger are expenses. Thus, accounting profits become lower and, in turn, so do taxes, which are a cash flow item.
10-3. If a project requires an increased investment in working capital, the amount of this investment should be considered as part of the initial outlay associated with the project 's acceptance. Since this investment in working capital is never "consumed," an offsetting inflow of the same size as the working capital 's initial outlay will occur at the termination of the project corresponding to the recapture of this working capital. In effect, only the time value of money associated with the working capital investment is lost.
10-4. When evaluating a capital budgeting proposal, sunk costs are ignored. We are interested in only the incremental after-tax cash flows to the company as a whole. Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows. Hence, they are
Cash Flows and Other Topics
in Capital Budgeting
ANSWERS TO
END-OF-CHAPTER QUESTIONS
10-1. We focus on cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest. Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost. Also, we are only interested in these cash flows on an after tax basis as only those flows are available to the shareholder. In addition, it is only the incremental cash flows that interest us, because, looking at the project from the point of the company as a whole, the incremental cash flows are the marginal benefits from the project and, as such, are the increased value to the firm from accepting the project.
10-2. Although depreciation is not a cash flow item, it does affect the level of the differential cash flows over the project 's life because of its effect on taxes. Depreciation is an expense item and, the more depreciation incurred, the larger are expenses. Thus, accounting profits become lower and, in turn, so do taxes, which are a cash flow item.
10-3. If a project requires an increased investment in working capital, the amount of this investment should be considered as part of the initial outlay associated with the project 's acceptance. Since this investment in working capital is never "consumed," an offsetting inflow of the same size as the working capital 's initial outlay will occur at the termination of the project corresponding to the recapture of this working capital. In effect, only the time value of money associated with the working capital investment is lost.
10-4. When evaluating a capital budgeting proposal, sunk costs are ignored. We are interested in only the incremental after-tax cash flows to the company as a whole. Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows. Hence, they are