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11.Cash Flows and Capital Budgeting

# 11.Cash Flows and Capital Budgeting - Chapter 11 Cash Flows...

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Chapter 11 Cash Flows and Capital Budgeting Learning Objectives 1. Explain why incremental after-tax free cash flows are relevant in evaluating a project, and be able to calculate them for a project. 2. Discuss the five general rules for incremental after-tax free cash flow calculations, and explain why cash flows stated in nominal (real) dollars should be discounted using a nominal (real) discount rate. 3. Describe how distinguishing between variable and fixed costs can be useful in forecasting operating expenses. 4. Explain the concept of equivalent annual cost, and be able to use it to compare projects with unequal lives, decide when to replace an existing asset, and calculate the opportunity cost of using an existing asset. 5 . Determine the appropriate time to harvest an asset. I. Chapter Outline 1

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11.1 Calculating Project Cash Flows In capital budgeting, we estimate the NPV of the cash flows that a project is expected to produce in the future. All of the cash flow estimates are forward-looking. A. Incremental After-Tax Free Cash Flows The cash flows we discount in an NPV analysis are the incremental after-tax free cash flows , which refers to the fact that these cash flows reflect the amount by which the firm’s total after-tax free cash flows will change if the project is adopted. See Equation 11.1: o FCF Project = FCF Firm with project – FCF Firm without project The term free cash flows (FCF) refers to the fact that the firm is free to distribute these cash flows to creditors and stockholders because these are the cash flows that are left over after a firm has made necessary investments in working capital and long-term assets. B. The FCF Calculation Referring to 11.2, which is a more detailed version of 11.1: FCF = [(Revenue – Op Exp – D&A) x (1 – t We first compute the incremental cash flow from operations (CF Opns), which is the cash flow that the project is expected to generate after all operating expenses and taxes have been paid. We then subtract the incremental capital expenditures (Cap Ex) and incremental additions to working capital (Add WC) required for the project to obtain FCF. 2
The FCF is therefore a measure of the after-tax cash flows from operations over and above what is necessary to make any required investments. The idea that we can evaluate the cash flows from a project independently of the cash flows for the firm is known as the stand-alone principle . It is another way of saying that we can treat the project as if it is a stand-alone firm that has its own revenue, expenses, and investment requirements. C.

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11.Cash Flows and Capital Budgeting - Chapter 11 Cash Flows...

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