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
(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 Cashflows:
– Use Cashflows
not accounting income
Ild
i
d
f
ft
– Include side effects
– Include opportunity costs
– Ignore sunk costs
– Exclude financing charges
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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 debtholders after a firm has made
necessary investments in working capital and longterm
assets
• Include taxation
Æ
(make cashflows aftertax)
– Use Incremental AFTERTAX 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
8
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 straightline basis over the
10year life of the project. The centre will have to invest $1mil
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 Spring '10
 ala
 Net Present Value

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