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wk9_10 - EC150: FINANCIAL ECONOMICS Slide Set 6: Applying...

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EC150: FINANCIAL ECONOMICS Slide Set 6: Applying the NPV Method to Evaluate Corporate Investments. (BASED ON RWJ CHAPTERS 7 (7.1 - 7.3)
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Introduction to Capital Budgeting Review NPV criterion Define Incremental Cash Flows Capital Budgeting then applies the NPV criterion to the incremental cash flows of a coprorate investment project Example: Baldwin Company
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More on Net Present Value and its Application While other approaches (particularly IRR) can be of use, we recommend NPV. The three steps to apply NPV: Estimate incremental cash flows, period by period. Select the appropriate discount rate to reflect current capital market conditions and risk. Compute the present value of the cash flows.
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Incremental Cash Flows The incremental cash flow in a given period is the company’s total cash flow with the proposed project less the company’s total cash flow without the project. Some issues that arise: Sunk costs. These are costs that have already been incurred. Opportunity costs. What else could be done? Capital investments vs. Depreciation expense. Side effects. Does the new project affect other cash flows of the firm? Taxes. Working capital.
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Sunk Costs vs. Opportunity Costs Last year, you purchased a plot of land for $2.5 million. Currently, its market value is $2.0 million. You are considering placing a new retail outlet on this land. How should the land cost be evaluated for purposes of projecting the cash flows that will become part of the NPV analysis?
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Side Effects A further difficulty in determining cash flows from a project comes from effects the proposed project may have on other parts of the firm. The most important side effect is called erosion. This is cash flow transferred from existing operations to the project. Chrysler’s introduction of the minivan. Chrysler’s introduction of the minivan. What if a competitor would introduce the new What if a competitor would introduce the new product if your company does not? product if your company does not?
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Taxes Typically, Revenues are taxable when accrued, Expenses are deductible when accrued, Capital Investments are not deductible, but depreciation can be deducted as it is accrued, tax depreciation can differ from that reported on financial statements, Sale of an asset for a price other than its tax basis (original price less accumulated tax depreciation) leads to a capital gains tax.
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Taxes - example Suppose a $100,000 asset has been depreciated to $25,000 It is sold at that point. Then, there is a capital gain of 100,000 - 25,000 = 75000 If the tax rate is 34% , the bill is .34(75000) = 25500
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Income Taxes and After-Tax Operating Cash Flow (OCF) OCF = R - E - taxes where R = taxable revenues, E = taxable expenses excluding depreciation. . taxes = (R - E - D)t - C,
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wk9_10 - EC150: FINANCIAL ECONOMICS Slide Set 6: Applying...

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