Define sunk costs.
Costs that have already been incurred, are unavoidable in the future, and will not vary with the course of action taken
What is the formula for after-tax cash flow?
(1.0 - Tax Rate) x Pre-tax cash flows = After-tax cash flow
The forumla for computing a depreciation tax shield is:
Tax rate x depreciation deduction
What are the three general stages in which capital investment cash flows are categorized?
- Cash flows at the inception of the project
- Operating cash flows
- Cash flows from the disposal of the project
What approaches can management take to select the desired rate of return for a project?
- Use a weighted average cost of capital (WACC) method
- Assign a target rate for new projects
- Recommend that the discount rate be related to the risk of the project
Define net present value (NPV)
Difference between the present value of the cash inflows and outflows from a project
How are investment decisions made using the NPV method?
- If NPV is positive, then the investment should be made.
- If NPV is negative, then the investment should not be made.
What is the profitability index?
Ratio of the present value of net future cash inflows to the present value of the net initial investment.
The higher the profitability index, the more desirable the project.
Define internal rate of return (IRR)
Discount rate at which the present value of the cash inflows equals the present value of the cash outflows from an investment/project
How are investment decisions made using IRR?
When IRR exceeds the hurdle rate
What is the payback method formula?
Payback period = Net initial investment / increase in annual net after-tax cash flow
