chapter9a - Chapter 9 Making Investment Decisions How to...

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Chapter 9 Making Investment Decisions How to determine the relevant cash flows How to analyze a project’s projected cash flows
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Relevant Cash Flows Always use cash flows rather than accounting figures in NPV calculations Always use incremental cash flows. What does this mean? You should always ask yourself “Will this cash flow change occur ONLY if we accept the project?” If the answer is “yes,” it should be included in the analysis because it is incremental If the answer is “no,” it should not be included in the analysis because it is not affected by the project If the answer is “part of it,” then we should include the part that occurs because of the project
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Incremental Cash Flows (1) Sunk costs should be ignored in calculating incremental flows - Costs that have already occurred. Example : if you have already paid for a marketing study, the cost already paid (i.e,. sunk) should have no bearing on your calculations or decisions. (2) Opportunity costs should be included in calculating incremental cash flows. Example : if you own a piece of land that you will use to build a factory, the value of that land must be treated as a cost
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(3) All negative or positive side effects should be included in incremental flows Example : producing new economy car will generate more profitable future sales of existing projects as customers become attached to your brand – positive side effect (synergy) Example : developing new jumbo jet line will erode some sales of existing lines – negative side effect (erosion) Incremental Cash Flows (continued)
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chapter9a - Chapter 9 Making Investment Decisions How to...

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