E.1. Capital Investment Analysis and Cash Flows Flashcards

Also called capital budgeting, is the process used to evaluate potential major projects or investments.

Recognizes that a $1,000,000 net cash inflow received next year is worth more than a $1,000,000 net cash inflow received five years from now.

• Identification
• Search
• Information-Acquisition
• Selection
• Financing
• Implementation and Control

After-tax net operating cash flows include incremental operating cash receipts net of related cash disbursements, net of applicable taxes, plus the depreciation tax shield.

The weighted average cost of after-tax interest on debt and the implicit and explicit costs of equity capital.

The cost of capital is the starting point for determining the required rate of return for a capital investment project.

A cost that has already been incurred and therefore is not relevant in decision making since it will not be changed by any new decision.

Cash flow is cash receipts net of related cash disbursements, while accounting profit is determined on the income statement using generally accepted accounting principles.

They are expected future cash flows that differ between alternatives.

In capital investment analysis, relevant cash flows must be included and cash flows that are not relevant must be excluded from the decision-making process.

It is the expected value of the forecasted cash flows for that year.

An expected value is the weighted average of all possible outcomes using the probabilities of each outcome as the weights.

At the very beginning of the first year of the project, identified as “Year 0” or “Time 0.”

The cash flow is multiplied by (1 − the tax rate) to calculate its after-tax equivalent because the outflow reduces taxable income and thus the tax due, reducing the net outflow amount.

• Initial investment in fixed assets, an outflow
• Initial working capital investment, an outflow
• Cash received from the disposal of old or outdated assets is a cash inflow at the beginning of the project that, after the effect of income taxes, reduces the net initial cash outflow for the newer assets.

There is no immediate tax effect with respect to the initial investment. However, tax benefits will arise over the life of the project as the capital assets are depreciated on the tax return.

Net working capital will increase by the amount of the increase in current assets related to the project net of the amount of the increase in current liabilities related to the project.

The increase in net working capital is a cash outflow in the capital investment analysis at the beginning of the project.

The gain or loss is the difference between the cash received for the asset and the tax basis of the asset when it is disposed of.

The tax basis is the asset’s book value for tax reporting purposes, which may be different from the asset’s book value for financial reporting purposes.