Asked by Teesean Patterson on Apr 26, 2024
Verified
A company is considering a proposed new plant that would increase productive capacity.Which of the following statements is correct?
A) In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, it would in effect be "double-counted."
B) Since depreciation is a noncash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
C) When estimating the project's operating cash flows, it is important to include any opportunity costs and sunk costs, but the firm should ignore cash flow effects of externalities since they are accounted for in the discounting process.
D) Capital budgeting decisions should be based on before-tax cash flows.
Operating Cash Flows
Cash generated from a company’s normal business operations, indicating the company's ability to generate sufficient positive cash flow to maintain and grow its operations.
Financing Costs
Financing Costs encompass expenses associated with raising capital to finance a company's operations or to fund expansion, including interest payments on debt and costs related to issuing equity.
Interest Expense
The cost incurred by an entity for borrowed funds, typically reflected as a line item in the income statement.
- Learn the essential elements of capital budgeting and the critical importance of cash flow versus accounting profit.
- Comprehend the necessity of using an appropriate risk-adjusted rate to discount cash flows.
Verified Answer
PG
Pedro GuzmanMay 03, 2024
Final Answer :
A
Explanation :
The cost of financing is already accounted for in the discount rate used to calculate the Net Present Value (NPV) of the project. Deducting financing costs again in the cash flow calculations would result in double counting. Therefore, financing costs such as interest expense should not be deducted when calculating the project's operating cash flows.
B is incorrect because although depreciation is a noncash expense, it is still important to account for it when calculating the project's after-tax operating cash flows.
C is incorrect because externalities such as the cash flow effects of positive/negative spillover effects on other projects/lines of business may impact the project's operating cash flows and should be accounted for in the analysis.
D is incorrect because capital budgeting decisions should be based on after-tax cash flows.
B is incorrect because although depreciation is a noncash expense, it is still important to account for it when calculating the project's after-tax operating cash flows.
C is incorrect because externalities such as the cash flow effects of positive/negative spillover effects on other projects/lines of business may impact the project's operating cash flows and should be accounted for in the analysis.
D is incorrect because capital budgeting decisions should be based on after-tax cash flows.
Learning Objectives
- Learn the essential elements of capital budgeting and the critical importance of cash flow versus accounting profit.
- Comprehend the necessity of using an appropriate risk-adjusted rate to discount cash flows.