Chapter8 - Financial Management FINE 301-01/-02 Spring 2008...

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Financial Management FINE 301-01/-02 Spring 2008 C HAPTER 8: Using Discounted Cash Flow Analysis to Make Investment Decisions Cash Flow vs. Accounting Income Discount cash flows Using accounting income, rather than cash flows, can lead to erroneous decisions. Example A project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare NPV using cash flow to NPV using accounting income. NPV using accounting income: Year 1 Year 2 Cash Income $1,500 $ 500 Depreciation -1,000 -1,000 Accounting Income +$500 -$500 NPV using cash flow: Today Year 1 Year 2 Cash Income $1,500 $ 500 Project Cost -$2,000 Free Cash Flow -$2,000 +$1,500 $500
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Determine incremental cash flows: Estimate cash flows if project is accepted Estimate cash flows if project is not undertaken The difference is the incremental cash flow Incremental Cash Flow = Cash Flow with Project – Cash Flow without Project When identifying project cash flows: Include all indirect effects Do not include sunk costs Include opportunity cost of cash flow Include the investment in working capital Beware of allocated overhead costs Include All Indirect Effects Is the new product a substitute or complement to your existing products? A substitute for existing products may cannibalize sales When Vista was in the development stage, Microsoft expected a decrease in Windows’ sales revenue A complement may increase sales for existing products A flight from a regional to an international airport that by itself is not attractive but will increase revenue out of the larger airport enough to make it acceptable Do Not Include Sunk Costs Sunk costs exist whether the project is accepted or not A consulting firm contracted to perform a feasibility study for a new project must be paid regardless of its findings A firm is deciding between 2 potential sites for a new factory and must have both surveyed to make the decision Include Opportunity Cost of Cash Flows The benefit or cash flow foregone as a result of using resources for one project rather than an alternative project A firm owns land worth $100,000. If a factory is built on the land, the firm must forego the cash from selling it. This is not the opportunity cost of capital, which is the
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Chapter8 - Financial Management FINE 301-01/-02 Spring 2008...

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