Making Capital Investment Decisions - Chapter 10

Flashcards covering the essential vocabulary and concepts for making capital investment decisions, including cash flow types, depreciation methods, and project evaluation approaches.

Relevant cash flow

A change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take a project.

Incremental cash flows

The difference between a firm’s future cash flows with a project and those without the project.

Stand-alone principle

The assumption that evaluation of a project may be based on the project’s incremental cash flows, viewing the project as a "minifirm."

Sunk cost

A cost that has already been incurred and cannot be removed and therefore should not be considered in an investment decision.

Opportunity cost

The most valuable alternative that is given up if a particular investment is undertaken.

Erosion

A side effect that occurs when the cash flows of a new project come at the expense of a firm’s existing projects.

Net working capital (NWC)

An investment in cash on hand, inventories, and accounts receivable required for a project that closely resembles a loan.

Pro forma financial statements

Financial statements that project future years’ operations for a proposed project.

Operating Cash Flow (OCF)

Calculated as: $OCF = \text{Earnings before interest and taxes} + \text{Depreciation} - \text{Taxes}$

Project cash flow

The total cash flow from a project calculated as: $\text{Project operating cash flow} - \text{Project change in net working capital} - \text{Project capital spending}$

Average accounting return (AAR)

Calculated as average net income divided by average book value.

Accelerated Cost Recovery System (ACRS)

A depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications.

Modified ACRS depreciation (MACRS)

A depreciation system where every asset is assigned to a particular class and depreciation is computed by multiplying the cost of the asset by a fixed percentage.

Bonus depreciation

A tax provision allowing a firm to take a depreciation deduction of 100% of the cost on an eligible asset in the first year (active 2018–2022).

Bottom-up approach

Calculating OCF by starting with net income and adding back any noncash deductions such as depreciation; only correct if there is no interest expense.

Top-down approach

Calculating OCF by starting with sales and subtracting costs and taxes, leaving out any strictly noncash items such as depreciation.

Tax shield approach

A method of calculating OCF defined as: $OCF = (\text{Sales} - \text{Costs}) \times (1 - T_C) + \text{Depreciation} \times T_C$

Depreciation tax shield

The tax saving that results from the depreciation deduction, calculated as: $\text{Depreciation} \times \text{Tax Rate}$

Equivalent Annual Cost (EAC)

The present value of a project’s costs calculated on an annual basis; used when evaluating equipment options with different economic lives.