CPA Business Notes

Becker – 2008 Edition Chapter 3 Page 1 of 18

Chapter 3

Factors Affecting Financial Modeling and Decision MakingFinancial Manager is required to evaluate the business wisdom of different alternatives-

Use of financial models allows manager to predict outcomes for various alternatives usingdifferent assumptions for the variables included in the model.Steps needed to reach a decision:1.

Determine the strategic issues

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Enhance shareholder/firm value2.

Specify criteria and identify alternative courses of actiona.

Short-term quantifiable criteriab.

Non-quantifiable criteria3.

Perform analysis of relevant costs and strategic costsa.

Obtain informationb.

Make predictions about future costsc.

Consider strategic issues4.

Choose an alternative5.

Evaluate performance to provide feedbackRelevant data: future revenues and costs are relevant

if they change

as a result of selecting differentalternatives.

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Variable or fixed, but usually variable because they change with production volume and output

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Direct costs: costs that can be identified with or traced to a given cost object. Variable costs areusually direct costs.

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Prime costs: direct material and direct labor.

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Discretionary costs: costs arising from periodic budgeting decisions

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Incremental/differential costs: additional costs incurred to produce an additional amount of theunit over the present output

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Avoidable costs

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NOT RELEVANT COSTS

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They are sunk/historical costs

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Result from choosing one course of action instead of another.

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Cost or revenue that will be the same regardless of the decision

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Absorption costs

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fixed manufacturing overhead (i.e. insurance costs). NOT relevant

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Value chain: defines each major activity that adds value to the product or service produced byan organization

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Decisions regarding the value chain represent evaluation of the relevant costs at thehighest levelQualitative: not numerical. (employee morale and customer satisfaction.Quantitative: may be reduced to numerical measurements-

Financial: denominated in currency-

Non-financial: time/units producedProbability: chance an event will occur. Between 0 and 1.-

Objective probability: based on past outcome

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returns on stock market-

Subjective probability: based on an individual’s belief

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outcome of a lawsuit

Becker – 2008 Edition Chapter 3 Page 2 of 18Expected value: used to determine best course of action when there is uncertainty-

the weighted average of the probable outcomes-

difference between the expected payoff under certainty and the expected monetary value of the best alternative under uncertaintyExpected value = (probability of each outcome) x (its payoff) and summing the results

Financial Modeling for Capital Decisions

Capital budgeting

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which project to invest inCash flows:-

Direct effect- a company pays out or receives cash-

Indirect effect: transactions either indirectly associated (sale of old) or that represent non-cashactivity (depreciation) that produces cash benefits or obligation (tax benefit)-

Net effect: Goal

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PV cash inflow > cash outflowsStages of cash flows:-

Inception of the project:

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Time period = 0

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Net cost of new property, plant, and equipment (PPE)`Invoice + Shipping + Installation+/-

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working capital**- cash proceeds on sale of old (net of tax)Net cash outflow for new PPE**Additional working capital = increase in payroll, supplies expenses, or inventory requirements**Reduced working capital = just-in-time inventory system is a decrease in current assetsCash-in flows:-

Cash flows from operations of asset = annuity-

Depreciation tax shields create ongoing indirect cash flow-

Disposal of the investment at end of project = direct or indirect cash flow effectsPre-tax cash flows:-

Investment value = PV of cash flows that investors receive in future-

Cash outflows > cash inflows = UNPROFITABLEAfter-tax cash flows:-

Income taxes are deducted in estimating annual cash flows

Becker – 2008 Edition Chapter 3 Page 3 of 18Tax depreciation on new equipmentx Marginal tax rateTax Deduction/cash flow savings+ After tax CF on operationsTotal after-tax CF on operationsExcellent example on page B3-13!Accounting rate of return = an evaluation method that uses GAAP income rather than cash flowsDiscounted cash flow (DCF): capital budgeting technique that uses time value of money.-

Best method to use for long-run decisions-

Steps:

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Initial investment (cash outflow)

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Future cash inflows and outflows

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Rate of return desired for the project

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Hurdle rateRate of return:

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hurdle rate

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Weighted-average cost of capital (WACC) method

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Discount rate be related to the risk specific to the proposed projectDCF Limitation:

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It only uses a single growth rate, which is unrealistic as interest rates change over time

Calculate after tax cash flows = Annual net cash flow x (1 – tax rate)+ Add depreciation benefit = Depreciation x tax ratex Multiply result by appropriate present value of an annuity- Subtract initial cash outflowNet present value

Payback period: time period that is required for the net after-tax cash inflows to recover the initialinvestment.-

Liquidity: measures the time it will take to recover the initial investment-

Risk: sooner I recover my investment, the better-

Net cash inflows are assumed to be constant for each period during the life of the project-

Depreciation tax shield

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add to after-tax CFO