Chapter_10_Presentation - 10 Making Capital Investment...

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10 Making Capital Investment Decisions
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10-2 Relevant Cash Flows Relevant Cash Flows The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted These cash flows are called incremental cash flows The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
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10-3 Asking the Right Question Asking the Right Question You should always ask yourself “Will this cash flow occur ONLY if we accept the project?” If the answer is “yes”, it should be included in the analysis because it is incremental If the answer is “no”, it should not be included in the analysis because it will occur anyway If the answer is “part of it”, then we should include the part that occurs because of the project
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10-4 Common Types of Cash Flows Common Types of Cash Flows Sunk costs – costs that have accrued in the past. Not incremental Opportunity costs – costs of lost options Side effects Positive side effects – benefits to other projects Negative side effects – costs to other projects (erosion or cannibalization) Changes in net working capital: Increase at start-up, decrease at project completion Financing costs: not included in this analysis Taxes: focus on after-tax cash flow
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10-5 Opportunity Costs: Discussion Opportunity Costs: Discussion One common opportunity cost is land. If a firm bought a piece of land 5 years ago and built a plant on it today, is this an incremental cash flow? The purchase price is not, but the current market value is. The firm could sell the land today; the sale value is the opportunity cost of building on it instead.
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10-6 Pro Forma Statements and Cash Flow Pro Forma Statements and Cash Flow Capital budgeting relies heavily on pro forma accounting statements, particularly income statements Computing cash flows – refresher Operating Cash Flow (OCF) = EBIT + depreciation – taxes OCF = Net income + depreciation when there is no interest expense Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC
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10-7 Table 10.1 Pro Forma Income Table 10.1 Pro Forma Income Statement Statement Sales (50,000 units at $4.00/unit) $200,000 Variable Costs ($2.50/unit) 125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT $ 33,000 Taxes (34%) 11,220 Net Income $ 21,780
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10-8 Table 10.2 Projected Capital Table 10.2 Projected Capital Requirements Requirements Year 0 1 2 3 NWC $20,000 $20,000 $20,000 $0 NFA 90,000 60,000 30,000 0 Total $110,000 $80,000 $50,000 $20,000
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10-9 Table 10.5 Projected Total Cash Flows Table 10.5 Projected Total Cash Flows Year 0 1 2 3 OCF $51,780 $51,780 $51,780 Change in NWC -$20,000 20,000 NCS -$90,000 CFFA -$110,000 $51,780 $51,780 $71,780
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Chapter_10_Presentation - 10 Making Capital Investment...

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