CH10 - CHAPTER 10 Cash Flows and Other Topics in Capital...

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CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting Orientation : Capital budgeting involves the decision-making process with respect to investment in fixed assets; specifically, it involves measuring the incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project’s costs. This chapter focuses on the estimation of those cash flows based on various decision criteria, and how to adjust for the riskiness of a given project or combination of projects. I. What criteria should we use in the evaluation of alternative investment proposals? A. Use cash flows rather than accounting profits because cash flows allow us to correctly analyze the time element of the flows. B. Examine cash flows on an after-tax basis because they are the flows available to shareholders. C. Include only the incremental cash flows resulting from the investment decision. Ignore all other flows. II. Measuring free cash flows. We are interested in measuring the incremental after-tax cash flows, or free cash flows, resulting from the investment proposal. In general, there will be three major sources of cash flows: initial outlays, differential cash flows over the project's life, and terminal cash flows. A. Initial outlays include whatever cash flows are necessary to get the project in running order, for example: 1. The installed cost of the asset 156
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In the case of a replacement proposal, the selling price of the old machine plus (or minus) any tax gain (or loss) offsetting the initial outlay 3. Any expense items (for example, training) necessary for the operation of the proposal 4. Any other non-expense cash outlays required, such as increased working-capital needs B. Differential cash flows over the project's life include the incremental after-tax flows over the life of the project, for example: 1. Added revenue (less added selling expenses) for the proposal 2. Any labor and/or material savings incurred 3. Increases in overhead incurred 4. Changes in taxes. 5. Change in net working capital. 6. Change in capital spending. 7. Make sure calculations reflect the fact that while depreciation is an expense, it does not involve any cash flows. 8. A word of warning not to include financing charges (such as interest or preferred stock dividends), for they are implicitly taken care of in the discounting process. C. Terminal cash flows include any incremental cash flows that result at the termination of the project; for example: 1. The project's salvage value plus (or minus) any taxable gains or losses associated with the project 2. Any terminal cash flow needed, perhaps disposal of obsolete equipment 3. Recovery of any non-expense cash outlays associated with the project, such as recovery of increased working-capital needs associated with the proposal. 157
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This note was uploaded on 04/16/2008 for the course FIN 100 taught by Professor N/a during the Spring '08 term at Baylor.

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CH10 - CHAPTER 10 Cash Flows and Other Topics in Capital...

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