slides17 - Capital budgeting Part II In this chapter, we...

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Unformatted text preview: Capital budgeting Part II In this chapter, we will apply the tools discused in the previous chapter. The focus in this chapter is developing estimates of the cash flows that should be considered. As we go through these examples, it is very important to remember that plugging numbers into your calculator is the easy pert of the problem. The more important tasks are: coming up with good estimates for the cash flows determining the appropriate cost of capital dealing with uncertainty Introduction We begin with a quick review of what costs to include in the capital budgeting analysis.... 2 Stand-alone principle We will typically analyze each project as a stand-alone en- tity . Cash-flows for the rest of the firm that are unaffected by the adoption of the project can be ignored . 3 Incremental cash flows We will typically only need to worry about changes in cash flows associated with adopting the project. 4 Sunk costs Costs that have already been incurred and do not depend on whether the project is accepted are referred to as sunk costs . Sunk costs should be excluded from the analysis. Example: A consultant is hired to help evaluate whether a new project should be accepted. the cost of hiring the consultant is a sunk cost. This money is gone whether or not the project is adopted. 5 Opportunity costs If the project is accepted, some resources already available to the firm may be used (and thus unavailable for other uses ). The incremental cash flows resulting from these resources not being available for other projects are referred to as op- portunity costs . Opportunity costs should be included in the analysis. Example: If I already own a piece of land and am thinking about building a McDonalds on it, I should include the market value of the land as a cost of the project. I could sell the land if I decide not to build the restaurant. 6 Side effects Adoption of a project may cause indirect changes in cash flows. Such changes are referred to as ( side effects ). Examples: Introduction of a new product may siphon sales off of existing similar products ( erosion ). Example: When McDonalds introduced the Arch Deluxe sandwich, instead of generating new sales, it primarily reduced sales of Big MAcs and Quarter Pounders. A new product may also increase sales of related products. For example, when HP is thinking of introducing a new line of printers, you can be sure that they are thinking of the effects on ink and toner sales. 7 Changes in NWC Adoption of the project may require a change in net working capital . Additional cash may be needed to pay expenses Investment in inventory and accounts payable may also be needed....
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This note was uploaded on 03/31/2008 for the course FNCE 3010 taught by Professor Donchez,ro during the Fall '07 term at Colorado.

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slides17 - Capital budgeting Part II In this chapter, we...

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