Chapter 11 HW Questions

1. Calculating project cash flows: Why do we use forecasted incremental after-tax free
cash flows instead of forecasted accounting earnings in estimating the NPV of a project?
The shareholders of a firm are interested in the incremental cash flows which reflect the
impact of accepting a particular project on the overall cash flows of the firm so that is why
they are used in the NPV rather than the accounting earnings (Investopedia, 2014).

2. The FCF calculation: How do we calculate incremental after-tax free cash flows from
forecasted earnings of a project? What are the common adjustment items?
The incremental after tax-free cash flows from the forecasted earning is calculated by simply
adding the depreciation and amortization to the NOPAT. The adjustment required to the
earnings is to exclude the interest from it as the cost of financing the project is reflected in
discount rate used for the NPV calculation (Garcia, 2012). Other than that, we also need to
adjust for the depreciation and amortization tax shield, capital expenditures, and changes in
working capital (including receivables and payables).

3.

The FCF calculation: How do we adjust for depreciation when we calculate

incremental after-tax free cash flow from EBITDA? What is the intuition for the
adjustment?
The effect of tax shield is incorporated in the revenue as EBITDA incorporates the value of
depreciation and amortization in the value of EBIT but does not account for tax payment
(Investopedia, 2014).

4. Nominal versus real cash flows: What is the difference between nominal and real
cash flows? Which rate of return should we use to discount each type of cash flow?
Nominal cash flows refer to the actual dollar amount of money that a company expects to
take in or give out. Whereas the real cash flows are adjusted for inflation so that the change in
value over the time is reflected. The formula used to adjust for the rate of return (k) is :
1 + k = (1 + Pe) x (1 + r)
Where r is the real cost of capital, (Pe) is the expected rate of inflation and (r) is the real
rate of return (Anon, 2014).
Nominal rate of return must be used for nominal cash flows and real rate of return must be
used for real cash flows.

5.

Taxes and depreciation: What is the difference between average tax rate and

marginal tax rate? Which one should we use in calculating incremental after-tax cash
flows?
The average tax rate is the total taxes paid divided by total income. The marginal tax rate is
the tax paid on an additional dollar of income. Since we are concerned with the incremental
after tax cash flows so the marginal rate is used rather than the average tax rate (Buck, 2008).

7. Cash flows from operations: What are variable costs and fixed costs? What are some
examples of each? How are these costs estimated in forecasting operating expenses?
Variable costs are the ones that vary with the changes in the production level whereas the
fixed costs remain the same regardless of the level of production. The operating expenses
usually involve expenses such as rent, fees, bank charges, salary and wages etc which are all
fixed costs. When forecasting operating expenses, it is often useful to treat variable and fixed
costs separately. Separating fixed costs from the variable also makes it easier to identify the

factors that will cause them to change over time and therefore easier to forecast them.
(Investopedia, 2014).
Example of fixed costs can be rent, salary etc and variable costs are direct material and direct
labor.

8. Cash flows from operations: When forecasting operating expenses, explain the
difference between a fixed cost and a variable cost.
The difference between fixed and variable costs when forecasting the operating expenses is
mainly that fixed costs remain fixed despite of the changes in production level whereas the
variable costs varies directly with the changes in production level. Separating fixed costs
from the variable also makes it easier to identify the factors that will cause them to change
over time and therefore easier to forecast them (Investopedia, 2014).

12. Expected cash flows: Define expected cash flows, and explain why this concept is
important in evaluating projects.
Expected cash flows are the inflow of cash a firm expects to generate over the life of the
project. The reason why this is important is that it aids in analyzing whether the project is a
profit or a loss i.e. will it add value to the firm or be a cost to the shareholders instead. It is
the probability-weighted averages of the cash flows generated by the project under different
scenarios (Anon, 2011).

13. Projects with different lives: Explain the concept of equivalent annual cost and how
it is used to compare projects with different lives.
The equivalent annual cost is the annual cost in nominal terms. It is also defined as the annual
payment from an annuity with a life equivalent to the project with the same NPV. As this is

an annual cost, so the EAC for a project can be compared with another regardless of their
lives (Parrott, 2015).

14. Replace an existing asset: Explain how we determine the optimal time to replace an
existing asset with a new one.
Depending upon the analysis of benefits versus the costs associated with replacing an asset
with a new one, the decision is taken regardless of the time involved.

15. Projects with different lives: If you had to choose between one project with an
expected life of five years and a second project with an expected life of six years, how
could you do this without using the equivalent annual cost concept?
Without using the equivalent annual cost concept, projects with different lives are considered
to be invested in repeatedly over an identical period and then their NPVs are compared to
reach a conclusion (Anon, 2009).

References
Anon.

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2016, from http://econperspectives.blogspot.com/2008/12/marginal-tax-rates-versus-averagetax.html
Garcia, M. (2012). Difficulties in Determining Incremental Cash Flows. Retrieved Feb 18,
2016, from Chron: http://smallbusiness.chron.com/difficulties-determining-incremental-cashflows-81579.html
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