# FIN 571 Week 4 - DQ - 7643

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What are the two factors on which present value depends?

The two factors on which present value depend are the period and the rate at which future cash flow to be discounted.

Distinguish between operating leverage and financial leverage.

Operating leverage shows the ability of the company to use its operating resources. This one shows the relationship of fixed cost with contribution margin, the fixed cost will be on the lower side the increase in sales will bring increase in profit at faster rate. On the other hand the financial leverage is the ability of the company to use its debt financing. The higher the leverage the company will be more exposed to financial risk. These represent and provide an overview of the profitability of the company.

Define what we mean by the firm’s financing decision and the firm’s investment decision. What entities are on the “other side” of these decisions?

Financing is the provision of sources to provide resources of the business. Financing may be classified as debt and equity financing. When a company wants to buy an asset they can raise bonds or stocks. Investment decisions include buying of fixed assets and much more. In the end our financial decision will be based on the company benefit to get higher return. The company that is in the other side of these decisions is the companies that issue the stocks and bonds. These companies are the borrowers that make the financial activity as investors.

Explain the calculation of a project’s net salvage value.

The net salvage value is the after-tax net cash flow for terminating the project.

I found a great example to explain the net salvage value calculation:

Suppose XYZ Corporation is contemplating a capital budgeting project with capital assets that will be depreciated to a book value (B) of \$10,000 but that XYZ expects to have a salvage value (S) of \$18,000. XYZ's marginal tax rate (T) is 34%. Cleanup and removal expenses (REX) are expected to be \$1,000, and there will be no return of working capital (thus, the change in working capital, W, is zero). What is the net salvage value?

NSV= Net salvage value

T= tax rate

B= book value

REX= cleanup and removal expenses

W= working capital

Net salvage value = NSV = (1-T)S + TB - (1-T)REX + W = (1-0.34)\$18,000 + (0.34)\$10,000 - (1-0.34)\$1,000 + \$0 = \$11,880 + \$3,400 - \$660 = \$14,620.

What is the relationship between the nominal rate of return, the real rate of return, and the rate of inflation?

The nominal rate of return is a yield on an investment expressed in current dollars, without factoring-in compounding or discounting or the effect of inflation. While the real rate of return is rate of return after adjusting for inflation and the rate of inflation is the percentage increase in the price of goods and services, usually done annually.

Why is it important to recognize and exclude sunk costs from a capital budgeting analysis?

Because sunk costs are past and irreversible outflows. These are historical costs that should not affect the decision to accept or reject a certain project. If we invest more funds to a not justified project this can sink the project into failure losing cash at the same time.

Reference:

Emery, Finnerty,; Stowe. (2007). Corporate Financial Management(3rd ed.). New Jersey: Pearson-Prentice Hall.

Investor Words.com

Briefly describe the five steps in the capital budgeting process.

1. Determining the flow of information- the company must gather the data to compile a budget.

2. Deciding what you are going to measure- in this case the company must segment its operations.

3. Gathering historic data- first we gather sales information such as product lines, regions and customers, and secondly you gather expense information such as direct costs, indirect costs, fixed costs and variable costs.

4.  Making projections- here the company needs to start budgeting. They will have to make a projection for the performance of the upcoming year. They can do this by creating a: incremental budgeting, zero based budgeting or even a hybrid approach. Most people prefer using the incremental budgeting because is the simplest way of doing it.

5. Determining breakeven point- Break-even point comes with many ways depending on the needs, some common ones are:

Break Even by Units

Break even = Fixed costs/[(Sales Price per unit - Variable Costs per unit)/Sales Price per unit]

or

Break Even = Fixed Costs/(Contribution Margin per unit/Sales Price per unit)

Break Even by Sales

Break Even = Fixed Costs/(Sales Price per unit - Variable Costs per unit)

or;

Break Even = Fixed Costs/Contribution Margin per unit

Solution Description

What are the two factors on which present value depends?

The two factors on which present value depend are the period and the rate at which future cash flow to be discounted.

Distinguish between operating leverage and financial leverage.

Operating leverage shows the ability of the company to use its operating resources. This one shows the relationship of fixed cost with contribution margin, the fixed cost will be on the lower side the increase in sales will bring increase in profit at faster rate. On the other hand the financial leverage is the ability of the company to use its debt financing. The higher the leverage the company will be more exposed to financial risk. These represent and provide an overview of the profitability of the company.

Define what we mean by the firm’s financing decision and the firm’s investment decision. What entities are on the “other side” of these decisions?

Financing is the provision of sources to provide resources of the business. Financing may be classified as debt and equity financing. When a company wants to buy an asset they can raise bonds or stocks. Investment decisions include buying of fixed a