Chapter 8. Capital Budgeting

Chapter 8. Capital Budgeting - Capital Budgeting Chapter 8...

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Capital Budgeting Chapter 8 Finance 357
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Incremental Cash Flows In finance, cash flows are what determines the value of projects and companies. When we analyze a project, it is important to only use cash flows that are incremental to the project. In other words, if we would normally get a cash flow without doing the project, don’t include that cash flow when analyzing the project. Costs that have already occurred are called sunk costs , and should never be used to value a new project. 2
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Other Costs When considering a project, we should consider opportunity costs. For example, if our company is considering selling a warehouse that we own, but instead we use the warehouse for a new project, the cost of the warehouse should be included as a cost in our project analysis. It is an opportunity cost. It is also important to consider indirect costs to a project, such as erosion. Erosion occurs when a project will cause the cash flows of another project to decrease. In marketing, this is often called cannibalism. Synergy occurs when a new project increases the cash flows of an existing project. 3
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Allocated Costs It is common that a single expenditure will benefit multiple projects. Accountants will spread the cost of this expenditure over the projects that benefit form it. However, this allocated cost should only be viewed as a cash outflow of a project if it is an incremental cost of the project. 4
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Baldwin Company: An Example Baldwin Company is considering an investment in machinery for bowling ball production. Costs of test marketing (already spent): $250,000 Current market value of proposed factory site (which we own): $150,000 Cost of bowling ball machine: $100,000 (depreciated according to MACRS 5-year) Increase in net working capital: $10,000 Production (in units) by year during 5-year life of the machine: 5,000, 8,000, 12,000, 10,000, 6,000 5
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Baldwin Expansion Price during first year is $20; price increases 2% per year thereafter.
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