STUDY & REVIEW GUIDE – CHAPTERS 8 & 9

Chapter 8:

I. Be able to calculate initial investment for an expansion or replacement decision. This means being able to calculate book value and tax effect(s). Normally, you add the change in net working capital, if there is a figure for this, because it increases the size of the initial investment dollar outflow. Remember that NWC = CA-CL. So, if CA increase by $40,000, and CL increase by $18,000, NWC changes by ($40,000-$18,000) = $22,000. I would add this as the last step in getting initial investment. See Table 8.2, which will be on your cover sheet. You will also have the depreciation table on page 100, and you will use a 40% tax rate for all tax calculations. Remember to get the tax effect by: Sales Price – Book Value = Taxable Amount. If positive, you owe 40% of that taxable amount in taxes. If negative, you get back 40% of that taxable amount as a tax credit (because you have a loss on sale).

II. Be able to calculate incremental (after minus before) operating cash inflows for an expansion or replacement decision. Be careful to add depreciation expense to the net profit after tax to get operating cash inflow. You will be given Table 8.7, pg. 373, on your cover sheet.

III. Be able to calculate the terminal cash flow. Generally, you add the net working capital, because now you are calculating an inflow that comes back to the company at the end of the project’s life (they “go out of business” on this project or investment). The added net working capital invested at the beginning of the project’s life is now freed up, turned back into cash, for use elsewhere in the business. You will be given Table 8.10 on your exam cover sheet.

Chapter 9:

Be able to calculate payback, IRR, and NPV. Be able to interpret your answers. Be able to specify disadvantages and advantages of each of the three techniques. Also, know why IRR and NPV may give different rankings (and this matters when we have mutually exclusive investment alternatives and also to capital rationing situations).