Chapter 10

Chapter 10 - 1 BA 3341 Business Finance Nataliya...

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Unformatted text preview: 1 BA 3341 Business Finance Nataliya Polkovnichenko, Senior Lecturer 2 Now that we have established the superiority of NPV, lets revisit the steps involved in the capital budgeting process. First- Estimate cash flows in the project. Second- Determine an opportunity cost of capital. Third- Apply NPV Fourth- Determine the selected alternative and implement. We will now take a look at the first step 3 Discount Cash Flows, Not Profits Discount Incremental Cash Flows Separation of Investment & Financing Decisions Calculating Cash Flow Examples 4 Discount actual cash flows, not profits!!! Most analysis will start with an accounting projection This must be converted to cash flows for NPV analysis Using accounting income, rather than cash flow, could lead to erroneous decisions. Beware of non-cash items included in earnings Capital Expenditure versus Depreciation Working Capital Accruals Revenue versus Cash Received (A/R) Expense Recognition versus Cash Paid (A/P, Inv) 5 A project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income. 6 Depreciation per year would be $1,000 In this case, Profit = Cash flow Depreciation Therefore, profits for year-1 and year-2 are $500 and -$500 7 Therefore, the project should not be accepted. Discounting profits can give you a completely wrong picture of the project. 8 Include All Incidental Effects Will project help or hurt existing projects Forget Sunk Costs Earlier mistakes cant be corrected today Include Opportunity Costs Value alternative uses of existing assets (market value) Include Working Capital Effects Often new projects require increased investment in inventory or receivable. Beware of Allocated Overhead Is overhead allocated truly incremental? Incremental Cash Flow = Cash Flow with Project Cash Flow Without Project _ 9 Indirect effects (some examples): - Launch of a new product might hurt sales of existing products. - When an airline starts operating on a new route (say Mpls-NY), it might boost traffic on other routes as well (Madison-NY via Mpls). Sunk Costs : These are costs that remain irrespective of the project. - For example, imagine you purchased a hockey ticket before the season began. But, now the team is lousy and you got cold. Do you go to the game anyway because you paid good money for the ticket? In finance, the way to ask the question is: If this ticket cost me nothing, then would I go? 10 Current sales 10 million chips yearly @ price of $20 each New chip sales forecast 12 million chips yearly @ price of $25 each Old chip sales expected to fall to 3 million yearly Old chip costs $6 each, new chips cost $8 each What is proper yearly cash flow to use to evaluate PV of introduction of new chip? PV of introduction of new chip?...
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Chapter 10 - 1 BA 3341 Business Finance Nataliya...

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