BEC  Notes Chapter 3
http://cpacfa.blogspot.com
Factors affecting financial modelling and decision making
Relevant data  data, such as future revenues or costs, that change as a result of selecting different alternatives
•
Can either be fixed or variable, but usually variable
•
Direct costs
 costs that can be identified with or traced to a given cost object
•
Prime costs
•
Discrentionary costs
 costs arising from a periodic or annual budgeting decision (i.e. landscaping)
•
Incremental/differential costs
 additional costs incurred to produce an additional unit over current
output
•
Avoidable
 costs or revenues resulting from choosing one course of action instead of another
Not Relevant data
•
Unavoidable
 costs or revenues that will be the same regardless of the chosen course of action
•
Absorption costs
 represent the allocated portion of fixed mfg OH, and therefore are not relevant
Objective probability
 based on past outcomes (like returns on the stock market
Subjective probability
 based on an individuals belief about the likelihood of an event occurring (a lawsuit)
Expected value
 is the weighted avg of the probable outcomes
Expected value = (probability of each outcome * its payoff) then sum the results
Financial modelling for capital decisions
Cash flow direct effect  a company pays out or receives cash
Cash flow indirect effect  transactions either indirectly associated (sale of old assets) with a capital project or
that represent noncash activity (depreciation) that produce cash benefit (reduces taxable income)
Invoice price + cost of shipping + cost of installation
+/ Working capital [such as increase in payroll, supplies expenses or inventory requirements]
 Cash proceeds on sale of old asset net of tax
=
net cash outflow for new PPE
Tax depreciation on new PPE
* Marginal tax rate
= Depreciation tax shield
Aftertax cash flow on operations
+ Depreciation tax shield
= Total after tax cash flow on operations
* present value of annuity
 initial cash outflow
= Net Present Value (NPV)
Discounted cash flow (DCF) methods are considered the best methods to use for longrun decision because it
accounts for time value of money. However, it only uses a single growth rate, which is unrealistic as interest
rates change over time.
Payback period
 is simple to understand and focuses on the time period for return of investment (liquidity).
However, it ignores the time value of money. It shows the return of investment not the return on investment
(ignores cash flows occurring after initial investment is recovered)
1
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View Full DocumentBEC  Notes Chapter 3
http://cpacfa.blogspot.com
Net initial investment [cash outflow + change in WC  sale proceeds on old PPE]
÷
increase in annual net aftertax cash flow
[Aftertax cash flow on operations + Depreciation tax shield]
= payback period
The larger the denominator the shorter the payback period
Discounted payback method
 computes payback period using expected cash flows that are discounted by the
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 Spring '10
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 Net Present Value, Internal rate of return, aftertax cash flow

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