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Lecture 6_Student_6slides

Lecture 6_Student_6slides - Reminder FIN 221 Lecture 6 CH...

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1 FIN 221 Lecture 6 CH 11 1 Cash Flows and Capital Budgeting Reminder • 26 th April, next Monday is a public holiday. If you are in one of the Monday classes, you can go to any tutorial during the week. Relevant Reading Chapters • 11.1 • 11.2 5 general rules …calculations Nominal vs real cash flows Computing Terminal year FCF Computing Terminal year FCF (Ignore the discussion related to MACRS) 11.4 Projects with Different lives 4 Cash Flow Cash Flow Cash Flow PV PV PV (1+i) n R (1+k) n Cost of capital Sample Worksheet for NPV analysis Application of the NPV method Estimation of cash flows is critical then how? Know what to Include/Exclude in Cash-flows: – Use Cash-flows not accounting income I l d id ff t – Include side effects – Include opportunity costs – Ignore sunk costs – Exclude financing charges
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2 Application of the NPV method Only incremental free cash flows are relevant – Additional cash flows to be brought as a result of adopting a new project – Free Cash Flow: Cash flows available for distribution to both shareholder and debt-holders after a firm has made necessary investments in working capital and long-term assets Include taxation Æ (make cash-flows after-tax) – Use Incremental AFTER-TAX free cash flow Careful with treatment of Net working capital Careful with inflation Free Cash Flow Calculation Investments in property Plant, and equipment Other long term assets that Must be made if a project is Tax Deductible Expense Purchased Investments in working capital Items, such as account Receivable, inventory, and Account payable, that must be made if the project is pursued. FCF Example Suppose you work at an outdoor performing arts centre and are evaluating a project to increase the number of seats by building FOUR new box seating areas and adding 5,000 seats for the general public. Each box seating area is expected to generate $400,000 in incremental annual revenue while each of the new seats for the general public will generate $2,500 in incremental annual revenue. The incremental expenses associated with the new boxes and seating will amount to 60% of the revenues. The new construction will cost $10 million and will be fully depreciated on a straight-line basis over the 10-year life of the project. The centre will have to invest $1mil in additional working capital immediately which is to recovered in the last year of the project. The marginal tax rate is 30%.
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