Classnotes_Chapter_10

Classnotes_Chapter_10 - Classnotes Chapter 10 Chapter 10...

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Unformatted text preview: Classnotes Chapter 10 Chapter 10 Making Capital Investment Decisions In previous chapter you were given cash flows. In this chapter we calculate these cash flows. 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 You should always ask yourself Will this cash flow occur ONLY if we accept the project? 0. If the answer is yes, it should be included in the analysis because it is incremental 1. If the answer is no, it should not be included in the analysis because it will occur anyway 2. If the answer is part of it, then we should include the part that occurs because of the project 1 Classnotes Chapter 10 What cash flows should be included in a capital budgeting analysis? 1. Cash flows are considered when they occur, not when we make an accounting entry. E.g. taxes occur when we pay them not when we record them in our financial statements. 2. Only consider those cash flows which occur as a result of undertaking the project. That is, only consider incremental cash flows. 3. Use nominal cash flows (we are discounting by a nominal discount rate). 4. Use after tax numbers 5. Ignore sunk costs 6. Include opportunity costs 7. Only include overhead costs that increase as a result of undertaking the project 8. Depreciation is not a cash flow and should not be included in cash flow analysis. However, depreciation does give tax relief and this should be considered in the analysis. 9. Do not include financing costs in cash flows. Financing costs are captured in the discount rate. 2 Classnotes Chapter 10 Comprehensive Example see end of this file Pro Forma Statements and Cash Flow Capital budgeting relies heavily on pro forma accounting statements, particularly income statements Computing cash flows refresher 3. Operating Cash Flow (OCF) = EBIT + depreciation taxes 4. OCF = Net income + depreciation when there is no interest expense 5. Cash Flow From Assets (CFFA) = OCF net capital spending (NCS) changes in NWC CFFA (operating) is the relevant cash flow for capital budgeting purposes. Note only incremental cash flows are considered, and financing costs are not included in CFFA....
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Classnotes_Chapter_10 - Classnotes Chapter 10 Chapter 10...

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