Finance FINAL Exam

Third Exam Study Points CH 10: 2, 6, 7, 11, 13, 14, 21, 23, 29, , 30, 32, 33, 34, 35CH 11: 1, 2, 18CH 17: 1, 2, 3, 5, 7, 9, 10, 12, 14, 17, 19, 20, 22, 24voice recordings of practice examples
Ch. 10 Bonds and Stocks: Characteristics and Valuation A claim against the income or assets of an individual, business, or government.Examples:Shares of stockHome Mortgage Car Loan
As we see, in addition to retained earnings, businesses can raise funds by: Issue debt (bonds)Selling shares (external equity)Funds can be raised publicly or privately
Long-term Financing Sources for Business
Characteristics of Fixed-Income Securities: Bonds and Preferred StockDEBT Capital DEBT CAPITAL -A contract between borrower/lender-Bankruptcy/reorganization threat if contract is violated-Priority claim on assets, cash flow-Less return potential than equity-Little/no voice in management
General Terms Associated with Debt: Par value or Face ValueCoupon RateCoupon PaymentAnnual coupon = coupon rate x par value U.S. versus EurobondsSecured versus unsecured Registered versus Bearer bonds
Bond Covenants Impose restrictions or extra duties on the firmProtect bondholder stake in the firmIndenture and the role of the trustees
Bond Rating Examples
High-Yield or Junk Bonds
Bond Ratings -Measure likelihood of default; influenced by level of issuer’s cash flow, investor protection in the covenants-Acts as a market signal-Lower rating–>Higher risk–>Higher coupon rate on new issues
Credit Risk Samples
Time to Maturity U.S.: 10-to-30 years (typical)Eurobond: 7-to-10 year (typical)Callable bondsSinking fund
Reading Bond Quotes
Preferred Stock “Preferred” over common stock with a senior claim on earnings, assetsFixed dividend; par value is important!Usually non-voting
Other Features Cumulative versus non-cumulativeCallableConvertibleTax Advantage
Characteristics of Variable-Income Securities: Common StockCOMMON STOCK Owners of the firmSelect DirectorsDividends: when declaredLowest priority in bankruptcyPar value–meaninglessDifferent classes to protect control
Reading Stock Quotes
How do firms decide how much to pay in dividends? Important influences:-Ability of firm to generate cash to sustain level of dividends-Legal/contractual considerations (par value, bond indenture)-Growth opportunities facing firm-Cost of other financing sources-Tax rates on dividend income
Stock Split Firm distributes extra shares for every share owned2-for-1 split: for every share owned, you receive another share. If you owned 100 shares you now own 200.But stock price will adjust so shareholder wealth is constantReverse split: 1-for-2: number of shares cut in half—you owned 200 shares, now you own only 100 shares. Share price adjusts so change in wealth = 0.
Why Offer Stock Splits? PsychologicalInvestors believe they are getting more Illusion of wealth raisingIs there an “optimal” price range for stock?If so, splits/reverse splits/dividends can move price back toward the desired range.Exceptions: Berkshire Hathaway ($100,000/share) and other firms with prices in excess of $100/share (Google in 2007: $500)
Share Repurchases Why buy back stock?Major reasons: -Reward long-term shareholders as less shares should increase stock price over time; -Firm sees stock as overvalued and as a good investment of excess fundsMinor reasons:-Acquire shares for management incentive stock options-Use in acquisitions
Valuation of Securities Valuation Principles Basic concept:Price of an asset = Present value of future expected cash flows
Continued
Bond Valuation Bonds: Cash Flows (interest points or sell price/maturity) (1) perpetual bonds-(pay interest only; no maturity) Po=I/Rd(2) zero-coupon bond (pays no interest; maturity higher) Po=M(PVIF)(3) coupon bond (pay interest and pays maturity) Po=I(PVIF)+M(PVIF) Preferred: Po=Dp/RpCommon Stock (1) zero growth Po=D/rs(2) constant growth Po=D/rs-q(3) non-constant growth Po=
The Seesaw Effect Required rate of return (the market interest rate) rises…bond prices fallInterest rate = 8.16% price = $1000Interest rate = 10.25% price = $875.48Required rate of return falls, bond prices riseInterest rate = 6.09% price = $1149.08
Perpetual Bond A perpetual bond pays a fixed coupon amount, I, forever.
Zero Coupon Bonds
Risks in Bond Investing Credit risk (default risk)Interest rate risk (seesaw effect)Reinvestment rate riskSpecial risks for non-domestic bonds:Political riskExchange rate risk
Valuation of Stocks Same principal:Price = Present Value of expected future cash flowsBut tougher to apply than with bonds:indefinite lifecash flows (dividends) uncertaindiscount rate hard to determine**a share of preferred stock that doesn’t mature and can’t be called will pay the same dividend amount Dp forever
Dividend Growth Patterns
Applications of the General Valuation Model -zero growth dividend valuation model -constant dividends over time Po=Do/RsPo=$2/0.10=$20
Gordon or constant dividend growth model
Risks in Stock Valuation Quality of management’s ethics, decisionsUncertainty over future dividend changes, growth changesChanging market/investor expectations for firms, the economyChanging interest rates
Valuation and the Financial Environment Economic events affect firms’Cash flowsRequired rates of return-Inflation-Risk Premium
Global Economic Influences Condition of non-domestic economies-Exports-Imports and domestic competitionChanges in exchange rates-Affect cash flows-Affects domestic interest rates
Domestic Economic Influences Consumers affect cash flows-Higher disposable income–> higher spending–>higher levels of business production, investment, and hiring–>economic growth, firm’s profitabilityEconomic conditions affect required return-Inflation-Investor optimism/pessimism on credit spreads, risk premiums
Domestic Economic Influences.. Government:-Fiscal policy: affects consumers’ disposable income-Monetary policy: affects interest rates, inflation expectations
CH. 10 Discussion Questions 2. What are the major sources of long-term funds available to business corporations? Indicate their relative importance. Internally generated funds arise from the firm’s retained cash profits and depreciation. External funds are obtained from debt (e.g., bonds) and equity (preferred stock, common stock) markets. Such debt and equity claims can be sold to the public or can be privately placed. Businesses raise more funds from debt than equity; more common stock is issued than preferred. Banks loans are an important source of intermediate-term funds.6. Describe what is meant by bond covenants.Covenants impose additional restrictions (negative covenants) or duties (positive covenants) on the firm. Examples of positive covenants include maintaining a minimum level of working capital and submitting audited financial statements to bondholders. Examples of negative covenants include restrictions on the amount of a firm’s debt or limits on dividends.7. What are bond ratings?Bond ratings are purchased by a firm issuing bonds in order to have a third party (the bond rating agency) evaluate the credit or default risk of a bond issue. The ratings inform the markets of the safety of the issue. The raters assess both the ability of the issuer to make timely interest and principal payments as well as the collateral and covenants specified in the bond indenture.11. Why might a firm want to maintain a high bond rating? What has been happening to bond ratings in recent years?There are two reasons why a firm might want to maintain a high bond rating. First was the prestige associated with having a high bond rating. Such firms are thought of being financially stable, well-managed, and might attract a number of institutional and individual investors. Second, a high bond rating saves the firm money by allowing it to have lower interest expenses on its bond debt.Over time, the stigma associated with high-yield or junk debt has diminished. Interest is tax-deductible whereas dividends are not; firms have issued debt to fund stock repurchase programs. Over time the percentage of investment-grade debt has fallen and the percentage of “junk” debt has risen. 13. Briefly describe how securities are valued.Future cash flows are estimated. The security’s value or price is the present value of these cash flows, discounted at an appropriate discount rate.14. Describe the process for valuing a bond.Determining the value of a bond is a three-step process: First, we must find the present value of the coupon payments. The annual coupon payment is the coupon rate multiplied by the par value. If interest is paid semiannually, this amount is divided in half and the resulting amount is paid every six months. The time horizon is the number of years, until maturity, for a bond with annual coupon payments and the number of years, times two, for a bond with semiannual coupons. The discount rate is the periodic rate, determined by whether the yearly rate is quoted on a nominal (APR) basis or effective yield (EAR) basis.Second, the present value of the par value is computed, using the same number of periods and periodic rate as that used for the coupons.Third, the sum of the present value of the coupons and the present value of the par value is the price of the bond.21. What is a “flight to quality”? Under what economic conditions might we see this?A flight to quality occurs when investors become nervous about future economic conditions. Less willing to take risks, they pull their funds from higher-risk investments and place them in securities that are perceived to be safer such as high-quality corporate bonds, federal agencies, and Treasury securities. This can be precipitated by fears of a coming recession, political uncertainty in a country, or economic uncertainty caused by, for example, rising oil prices, inflation, or widespread labor strikes. Higher credit risk securities will be perceived to have a much greater chance of default as we enter a recession so investors will opt for safer securities.23. Why should investors consider common stock as an investment vehicle if they have a long-term time horizon? An analysis of returns on an after-tax, after-inflation basis shows that common stocks have earned positive returns over time. Other securities, such as Treasury bonds, have lower after-tax returns while others (such as T-bills have lost money after calculating real, after-tax returns. 29. Describe some of the characteristics of common stock.Common stock represents ownership in the firm. Common shareholders can vote for the firm’s board of directors and other major issues as allowed by the firm’s charter. Common stock has a residual claim on the firm’s assets and earnings in case of bankruptcy. Some of the firm’s profits may be distributed to common shareholders if dividends are declared by the board of directors. The dividend can increase, decrease, remain stable, or be eliminated.30. List and briefly explain the special features usually associated with preferred stock.Preferred stock carries a fixed dividend, expressed either as a dollar amount or as a percent of par value. They have a preference over common shareholders with respect to earnings and assets in case of bankruptcy. Shareholders have no voting rights, except in certain circumstances if dividends are missed. It may be cumulative (all dividends in arrears must be paid before common shareholders receive dividends) or non-cumulative. Preferred stock can be convertible into shares of common stock or callable by the issuer.32. Explain how an investor may view a stock dividend, a stock split, and a stock repurchase plan with regards to the value of his stock holdings.Stock dividends and stock splits should have no impact on firm value; they are little more than accounting entries adjusting the number of shares outstanding by the firm and the number of shares owned by an investor. A share repurchase plan is viewed positively as the firm is using funds to reduce the amount of shares outstanding. Under the laws of supply and demand this will increase the stock price above what it would be otherwise. Any gains from stock price increases are deferred until an investor’s shares are sold.33. Describe the process for valuing a preferred stock.Since the cash dividends of a preferred stock are similar in nature to a perpetuity, they can be valued using the perpetuity relationship. This is usually done by dividing the periodic dividend by the preferred shareholders’ required rate of return.34. Describe the process for valuing a common stock when the cash dividend is expected to grow at a constant rate. As long as the expected growth rate is less than the common shareholders’ required rate of return, the Gordon model or constant dividend growth model can be used. Today’s stock price is estimated by dividing next year’s expected dividend (which is this year’s dividend increased by the growth rate) divided by the difference between the shareholders’ required return and the dividend growth rate.35. Discuss the risks faced by common shareholders that are not related to the general level of interest rates.As stockholders have a lower priority than bondholders on a firm’s cash flows and assets, any risk (poor management decisions, adverse change in exchange rates, competitive pressures, new products) that reduces cash flows or the value of a firm’s assets is primarily borne by a firm’s shareholders. Ethical lapses by management will harm a firm’s stock price. In addition, as the constant-growth model shows, much of a firm’s stock value is due to expectations of future growth. If growth expectations change due to economic or product market factors, the value of the stock will fall.
CH. 11 Securities Markets Issuing Securities: Primary Security Markets Primary versus secondary securities marketsInitial Public Offerings (IPOs)Investment Banks
Functions of Investments Banks Three Main Functions:-Origination-Underwriting-SellingOrigination-Public Offering-Private Placement-ProspectusUnderwriting-“Carrying the risk”-Best efforts -Shelf registration-Private placement
The Costs of Raising Capital The costs of issuing stocks and bonds are called “flotation costs.”-Out-of-pocket costs-Spread-UnderpricingThe sum of these costs can total 20-30% or more of the funds raisedHot/cold IPO markets
What else do Investment Banks do? Commercial paperMergers and acquisitionsManage investment funds (e.g., company pension funds)
Investment Banking Regulations Securities Act of 1933-Full, fair, and accurate disclosure-Prevent fraudSecurities Exchange Act of 1934-Established SEC-Brokers, dealers register with SECGlass-Steagall Act -Commercial banks cannot underwrite securitiesGramm-Leach-Bliley Act-Removed many restraints of Glass Steagall on financial services firms
Trading Securities: Secondary Securities Markets Organized Exchange versus Over-the-Counter (OTC)Organized Exchange: NYSENYSE is a private firm which went “public” in 2006 by acquiring a publicly traded firm (Archipelago) which offers electronic trading of securities
Over-The-Counter Market (OTC) NASDAQNot just for small firms-Intel, Apple, Microsoft
Security Transactions Bid price: offered by buyer Ask: requested by sellerSpread: the difference between them-Narrower spreads imply more liquidity and faster completion of a tradeTypical display:-Bid: 30.42 x 50900-Ask: 30.43 x 50800
Some issuing firms allow… Direct investing-Buy shares directly from the firmDividend Reinvestment Plan
How’s the Market Doing? Security Market Indexes are used to track overall market and sector performance for stocks, bonds, and other investmentsWell-known stock market indexes:-Dow Jones Industrial AverageBased on price-Standard & Poor’s (S&P) 500Based on market value
Wandering from Home: Investing Overseas Diversification benefitsHarder to do trades-Liquidity-Currency differences-Regulations, tax laws Solutions:-American Depository Receipts-Global Depository Receipts-Mutual funds–professional investing
Ethics Issues Insider tradingAn insider: someone with access to important non-public informationcan be a corporate officer, investment banker, major shareholderblue-collar workers, too (e.g., printing press operators)
CH. 11 discussion questions 1. Why do corporations employ investment bankers?Investment bankers have expertise in selling and distributing securities. They have sales networks and are constantly in touch with the financial market place. Corporations, on the other hand, infrequently issue securities; bankers do it all the time. Bankers’ expertise can help the issuer design the right security, obtain wide distribution, and obtain a fair price for it.2. Identify the primary market functions of investment bankers.They originate, or identify growing firms that can benefit from securities offerings. Here, the investment banker markets his or her firm as the best one to help the firm raise capital. They can underwrite, or carry the risk, of a new offering by using their capital to purchase the securities from the issuer and then selling the securities to investors. For small, high-risk issuers, they may assist in a best efforts offering by selling securities on a commission basis with no capital at risk. Investment bankers can also assist firms to sell shelf-registered securities or in privately placing securities.18. What factors differentiate a “good market” from a “poor market”?A good market has four characteristics. First, it will be liquid, meaning that trades are executed quickly at a price close to fair market value (which is usually the most recent transaction price). Such markets will have smaller bid-ask spreads, will have depth (the ability to do large trades without disrupting prices) and breadth (many traders).Second, a good market has quick and accurate trade execution. Traders will not have to wait long to receive confirmation of a completed transaction and its price.Third, the market will have reasonable listing requirements to denote, to traders, that firms of good-to-high quality have securities listed on the market. Standards that are too high will restrict the number of securities and will give the appearance of lower trading activity and possible lack of liquidity. Standards that are too low hurt the quality image an exchange wants to project.Fourth, trading occurs with low transactions costs. Securities can be listed at reasonable cost and transactions costs (which include both commissions and the bid-ask spread) for investors are low.
Ch. 17 Capital Budgeting Analysis Capital Budgeting Projects Seek investment opportunities to enhance a firm’s competitive advantage and increase shareholder wealth-Typically long-term projects-Should be evaluated by time value of money techniques-Large investmentMutually exclusive versus independent
Identifying Potential Capital Budget Projects Planning tools:MOGS: Mission, Objectives, Goals, StrategiesSWOT: (Internal to firm):Strengths, Weaknesses(External to firm): Opportunites, Threats
Capital Budgeting Process IdentificationDevelopment (Estimate cash flows)Selection (Apply decision criteria)ImplementationFollow-up (Audit)
Identifying Potential Capital Budget Projects. Inputs: cash in/outflows, required rate of return or “cost of capital”Net Present Value = Present value of expected cash flows – cost of projectIf NPV >0 the project adds value to the firm.Where do firms find attractive capital budgeting projects with potentially positive NPVs?
Generating Capital Investment Project Proposals Classifying Investment Projects-Projects Generated by Growth Opportunities-Projects Generated by Cost Reduction Opportunities-Projects Generated to Meet Legal Requirements and Health and Safety StandardsProject Size and the Decision-Making Process-Typically decentralized
Estimating Project Cash Flows Important concepts:Stand-alone principleIncremental after-tax cash flows from the base caseCannibalization or enhancement effectsOpportunity costs
Up-front or “time zero” investment Investment = cost + transportation, delivery, and installation charges
Project Stages and Cash Flow Estimation Initial Outlay-Engineering estimates (designs, modifications)-Current market prices of new items-Bid prices from possible supplies or construction firms-Will be reduced if new project is replacing old equipment/building that can be sold-Cash Flows During the Project’s Life-For each period of time during the project’s life, use the general equation:-OCF = (Sales-Costs-Depreciation)(1- t) + Depreciation – ΔNWC-Estimating the inputs: marketing studies, production cost estimates, suppliersSalvage Value and NWC Recovery-After-tax salvage value = Asset selling price – t (selling price – book value)-Project’s NWC may be assumed to be liquidated (converted to cash) and returned to the firm as a cash flow
Project Cash Flows – Project sales (generally a cash inflow)- Project costs (generally a cash outflow)- Depreciation (a noncash expense) EBIT = EBT (earnings before interest and taxes, which also equals earnings before taxes as financing costs are ignored in cash flow analysis) – Taxes (a cash outflow) Net income
Operating Cash Flow OCF = Net Income + Depreciation – ΔNWCFrom the project’s income statement, this is the same as:(Sales-Costs-Depreciation) – Taxes + Depreciation – ΔNWCIf the firm’s tax rate is t then Taxes = t(pre-tax income) = t(Sales-Costs-Depreciation)
The Depreciation Tax Shield
Forecasts Note the multiple uses of the word “forecast” in the previous listManagers must make educated guesses about the future to estimate future cash flows
NPV of Project A
NPV of Project B
What Does the NPV Represent?
Internal Rate of Return It is the discount rate that causes NPV to equal zero
Solution Methods Compute the IRR by:-Trial and error-Financial calculator-Spreadsheet softwareAccept the project if IRR > minimum required return on the project
What Does the IRR Measure? IRR measures the return earned on funds that remain internally invested in the project
NPV vs. IRR They will always agree on whether to accept or reject an independent projectSo if projects are independent: either method is acceptable Problem: they may rank projects differentlyWhat to do if projects are mutually exclusive and the rankings conflict?Answer: use NPV as it measures the change in shareholder wealth occurring because of the project.-Another issue with IRR: a project may have more than one IRR!-Can occur if project has alternative positive and negative cash flows.-Most likely to occur if project requires substantial renovations or maintenance during its life or if end-of-life shut-down costs are high
Profitability Ratio (Benefit/Cost Ratio) Profitability Index = Present value of cash flows/initial costAccept project if PI > 1.0Reject project if PI < 1.0Interpretation: Measures the present value of dollars received per dollar invested in the project
Project A and B Project A’s profitability ratio:PI = $21,982/$20,000 = 1.099Project B’s profitability ratio:PI = $25,988/$25,000 = 1.040
Relationships NPV, IRR, PI will always agree on the Accept/Reject decisionIf one indicates we should accept the project, they will all indicate “accept”NPV > 0 always means that: IRR>minimum required return and that the: PI > 1
Reject Decision, too If one indicates we should reject the project, they will all indicate “reject”NPV < 0 always means that the IRR < minimum required return and that the PI < 1
Conflicts Between NPV, IRR, Profitability Index May occur as different rankings may occur if projects are mutually exclusive. Most likely when projects have:Different cash flow patterns-Projects with larger and earlier cash flows may have higher IRR rankings than those with larger later cash flows
Conflicts Between NPV, IRR, Profitability Index Different Sizes-Projects with smaller initial investments may have higher IRR and higher PI and smaller NPV than projects with larger initial investments.Four discounted cash flow methods:NPV, IRR, profitability indexGoal in capital budgeting is to select projects that will help maximize shareholder wealth.NPV is the best as it measures the absolute dollar change in shareholder wealth.The others are relative measures of project attractiveness.
A popular, but flawed, measure… Payback period = number of years until the cash flows from a project equal the project’s costAccept project is payback period is less than a maximum desired time period
Project A Payback ExampleInvestment: $20,000
Payback’s Drawbacks Ignores time value of moneyAny relationship between the payback, the decision rule, and shareholder wealth maximization is purely coincidental!It ignores the cash flows beyond the payback period
What Managers Use 75% of CFOs used NPV, IRR or both to evaluate projectsIRR is most popularOver half still use payback as a secondary or supplementary method of analysis
Why Are IRR and Payback Used So Much? Safety margin-IRR gives managers an intuitive feel for a project’s “safety margin”—amount by which cash flows can be incorrect and the project can still increase shareholder wealth.Project SizeManagerial flexibility and options
Reality: Keeping Managers Honest Pet projects can be accepted into the capital budget by inflating cash flow estimates so their NPV is positivePossible solutions:-Review spending in implementation stage; additional requests for funds needed in case of overruns-Compare forecasted cash flows with actuals-Record names of those issuing forecasts
Cost of Capital Required return on average risk project = firm’s cost of capital, or cost of financingFor average risk projects, use this number as the discount rate (NPV, PI) or the minimum required rate of return (IRR)
Ch. 17 Discussion Questions 1. What is meant by capital budgeting? Briefly describe some characteristics of capital budgeting.Capital budgeting is the process of identifying, evaluating, and implementing a firm’s investment opportunities. Capital budgeting projects usually require large initial investments, and may involve acquiring or constructing plant and equipment. A project’s expected time frame may be as short as a year or as long as 20 or 30 years. Projects may include implementing new production technologies, new products, new markets, or mergers. 2. Why is proper management of fixed assets crucial to the success of a firm?The profitability of a firm is affected by the success of management in making capital budgeting decisions. A firm’s long-run strategy is implemented through capital budgeting. 3. How do “mutually exclusive” and “independent” projects differ?With mutually-exclusive projects, competing projects all have the same purpose or aim (for example, a new plant location, or computer system); selecting one eliminates the others from further consideration. If projects are independent, there is no relationship between them, so all acceptable projects (positive NPV) can be chosen. 5. Briefly describe the five stages in the capita- budgeting process.a. Identification: finding potential value-enhancing projectsb. Development: estimating a potential project’s cash inflows and outflowsc. Selection: applying decision techniques to accept or reject a projectd. Implementation: doing the projecte. Follow-up: auditing the progress of spending and cash flows to determine if the project is progressing satisfactorily 7. What kinds of financial data are needed in order to conduct the analysis of a project?Data needed include investment costs; estimates of revenues, costs, and after-tax cash flows; cost of capital estimate; publicly available data on competitors’ plans and operating results. 9. What is meant by a project’s net present value? How is it used for choosing projects?Net present value is the present value of a project’s cash flows minus the initial outlay. It measures the change in shareholder wealth if the project is chosen by the firm. All positive NPV projects should be done by the firm.10. Identify the internal rate of return method and describe how it is used in making capital budgeting decisions.The internal rate of return is the discount rate where the NPV is zero. It measures the return on the funds that remain internally invested in the project. Acceptable projects have IRRs greater than the project’s cost of capital.12. Describe the term “profitability index” and explain how it is used to compare projects.The profitability index is the present value of a project’s cash flows divided by the initial outlay. It measures, in present value terms, the benefits of a project per $1 of initial cost. Projects are acceptable if their PIs exceed one.14. Describe the payback period method for making capital budgeting decisions.The payback measures how long it takes for a project to repay its investment. The firm will accept projects with paybacks less than a management-specified maximum.17. What are the three types of relevant cash flows to be considered in analyzing a project?Incremental after-tax cash flows, cannibalization or enhancement effects, and opportunity costs are considered relevant when analyzing a project’s cash flows.19. What types of cash flows are considered to be irrelevant when analyzing a project?Sunk costs and financing costs are considered to be irrelevant when analyzing a project’s cash flows.20. “Our firm owns property around Chicago that would be an ideal location for the new warehouse. And since we already own the land there isn’t any cash flow needed to purchase it.” Do you agree or disagree with this statement? Explain. Disagree. The existing land’s value should be considered an opportunity cost in the warehouse’s capital budgeting analysis. Rather than used as a warehouse site the firm faces the alternative of selling the land at its market value and using the proceeds of the sale for the firm’s purposes.22. Classify each of the following as a sunk cost, an opportunity cost, or neither. a. The firm has spent $1 million thus far to develop the next-generation robotic arm; it is now examining whether the project should continue.Sunk cost; what should determine whether the project goes forward is future cash flow expectations and their net present value. b. A piece of ground owned by the firm can be used as the site for a new facility.Opportunity cost; the firm should consider its market value as a cost of using the site for the new facility. c. It is anticipated another $200,000 of R&D spending will be needed to work out the bugs of a new software package.Sunk cost; what should determine whether the project goes forward is future cash flow expectations and their net present value. 24. Why is the change in net working capital included in operating cash flow estimates?Changes in current asset and current liability accounts can add or detract from cash flows. For example, an increase in sales revenues may result in lower increase (or even a decrease) in cash inflows if the amount of credit sales causes accounts receivable to rise sufficiently. Similarly, an increase in costs may not have immediate negative cash flow implications if the added expenses create increases in accounts payable.

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