AF3313 - Lecture 4 - AF 3313 – Business Finance Lecture 4...

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AF 3313 Business Finance Lecture 4 Capital Budgeting
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1 Capital Budgeting Why do we need to do capital budgeting in the first place? It helps us to make decisions objectively with regard to maximizing corporation values. Among all the methodologies, managers should use Net Present Value (NPV) for making decisions. However, there are steps that you should follow in order to arrive at the NPV correctly. In order to calculate NPV of a project, a pro-forma model should be built. What exactly is a pro-forma model?
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2 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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3 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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4 Common Types of Cash Flows Sunk costs costs that have accrued in the past Opportunity costs costs forgone Side effects Positive side effects benefits to other projects Negative side effects costs to other projects Changes in net working capital Financing costs Taxes
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5 Sunk Costs Costs that has already occurred They cannot be changed by the decision of accepting or rejecting the project. Example : ABC company wants to evaluate a new project and pays $100,000 to a consulting firm to perform a market analysis . Should the ABC include this $100,000 in its capital budgeting decision? No, since such cost is irrecoverable . It is only relevant before it was sunk.
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6 Opportunity Costs Opportunities or benefits that a firm need to forgo if project was accepted. Example: Should I go to University? You expect higher salary after graduation and you need to pay tuition now also. What is your opportunity cost here? You could have worked these three years and earn salary and three years of salary is your opportunity cost. What are the natures of the opportunities or benefits foregone?
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7 Side Effects What are the side effects of the proposed project on the other parts of the firm? Example: If Toyota was considering developing a new convertible sports car, not all the sales and profits could be considered as incremental, since it might reduce sales of other Toyota cars.
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