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ch13 - Chapter 13 Capital Budgeting Estimating Cash Flows...

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Chapter 13 Capital Budgeting: Estimating Cash Flows and Analyzing Risk ANSWERS TO BEGINNING-OF-CHAPTER QUESTIONS 13-1 The firm’s FCFs reflect both its past and current investments. Past investments produce current FCFs, but current investments are expected to add to FCF at some future point. Conceptually, a project’s projected cash flows and are expected to contribute that same amount to the firm’s future free cash flows. In practice, project cash flows are analyzed to determine what projects the firm will invest in, and then the sum of those investments, and the cash flows they produce, will in the future be reflected in the firm’s FCFs. If a firm identifies and then invests in positive NPV projects, this will increase the value of its operations as determined by the FCF model. The central issue is analyzing individual projects, and here the key factor is assessing the cash flows. See the BOC spreadsheet model. We go through the model to show how capital budgeting projects are analyzed. In this case, the initial NPV, IRR, and MIRR, all evaluated at the 12% average cost of capital and using the expected input values, indicate that the firm should accept the project. However, the risk analysis as done in the scenario analysis indicates that the project is riskier than average, hence the evaluation should be done with a somewhat higher WACC. Note that firms have two types of assets—-assets-in-place (past investments) and growth opportunities. The FCF projections reflect the results of assets now in place and also its expected future investments from growth opportunities. 13-2 Externalities relate to effects that a given project might have on the firm’s other assets. More broadly, externalities relate to effects within and outside the firm. An internal externality might be a situation where a utility has an old and inefficient plant that is costly to operate and that also produces a lot of air pollution, and if a new plant is built, then the firm’s costs will be reduced and it will also pollute less and thus have lower external costs. Note, though, that the new plant will take production away from the old plant, and this is called “ cannibalization .” Internal externalities can also be positive. For example, if the firm agrees to build a generating plant that would help alleviate California’s energy shortage, then certain customers might agree to buy power from the firm’s other units and thus raise their profitability. Note too that if the company were required to deal with the pollution the plant created, this would convert the external cost to an internal cost, and the costs of the pollution mediation would have to be built directly into the cash flow analysis. Sunk costs are costs that have already been incurred, and on which the current decision will have no effect. For example, if a company had spent $2 million on an engineering feasibility study, then that $2 million would be a sunk cost. It should not be Answers and Solutions: 13 - 1
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worked into the current decision analysis. For the current decision, we are concerned only
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