BCOR 2200 Chapter 9

BCOR 2200 Chapter 9 - Chapter 9 Making Capital Investment...

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1 Chapter 9 Making Capital Investment Decisions
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2 We know from Chapter 8: Capital budgeting requires calculating the NPV: So Discount the future cash flows at the require rate of return But how do you determine the cash flows? And how do you know what discount rate to use? First we’ll look at cash flows Then we’ll look at the discount rate The General Idea: Only use CFs associated with the project being considered – New (or incremental) CFs. These are the relevant CFs for the analysis CFs from existing (or previous) operations are not relevant
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3 Chapter Outline: 1. The Stand-Alone Principle Use only Incremental or Relevant CFs 2. What CFs do you include? 3. Use of Pro-Forma Financial Statements 4. More About NWC and Depreciation 5. Evaluating NPV estimates 6. Scenario Analysis 7. Additional Considerations
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4 9.1 Project Cash Flows – A First Look Don’t calculate the whole firm’s CFs Calculate CFs With and Without the project Use the Stand-Alone Principle Calculate the Incremental CFs associated with the project Include any and all changes in the firm’s future CFs that are a direct consequence of taking on the project. These are the Relevant CFs use to calculate NPV
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5 9.2 Incremental CFs (Only those CFs that result from the project) Issues and Definitions associated with Identifying Incremental CFs: Sunk Costs: A cost already paid or a liability already incurred The decision about the project will not affect these costs. Example: Money spent studying a project before the decision is made. Not included since it is spent whether the project is accepted or not Example: Already paying a manager to manage one factory Allocate ½ the manager’s salary to the 2 nd factory The salary is a sunk cost Not included in the 2 nd factory CFs
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6 Two More Sunk Cost Examples: Example: One more $1 slot machine pull after loosing $100. Should you consider the past $100 when deciding to the next $1? The loss is not relevant in the decision to bet the next $1 Example: We tried to market a red version of our project and that didn’t work Should we try to market a blue version? Do we include the cost of the failed red version when deciding on the blue version? It is often tempting to try to “turn around” a previous bad decision or bad outcome “If we don’t go forward, those past losses were in vain” The only consideration should be changes that will occur going forward. Past costs are sunk costs
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Opportunity Costs If assets already owned are used in the project: Account for them at current market value Not the original cost If the assets are not used in the project, they could be sold at current market value Side Effects A new project might have spillover or side effects that must be included Good and Bad side effects A new product might Cannibalize existing products ( Erosion) New product might generate service revenue or sales of replacement parts
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This note was uploaded on 03/17/2009 for the course BCOR 2200 taught by Professor Tomnelson during the Fall '08 term at Colorado.

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BCOR 2200 Chapter 9 - Chapter 9 Making Capital Investment...

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