6[1]. capital_budgeting_investment_decision

6[1]. capital_budgeting_investment_decision - Capital...

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Capital Budgeting: Investment Decision Tom Connelly 2 References: z RWJ, Ch. 10 and 11 z Brigham and Houston, Fundamentals of FM, z Ch. 10, 11, and 12 3 Key Concepts and Skills z Understand how to determine the relevant cash flows for various types of proposed investments z Be able to compute depreciation expense for tax purposes z Understand the various methods for computing operating cash flow 4 Chapter Outline z Project Cash Flows: A First Look z Incremental Cash Flows z Pro Forma Financial Statements and Project Cash Flows z More on Project Cash Flow z Alternative Definitions of Operating Cash Flow z Some Special Cases of Cash Flow Analysis
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5 Relevant Cash Flows z In a capital budgeting analysis, include the cash flows that will only occur if the project is accepted z Include only the incremental cash flows z Stand-alone principle: analyze each project in isolation from the firm z Focus on incremental cash flows 6 Asking the Right Question z Ask: “Will this cash flow occur ONLY if we accept the project?” z If “yes”, the CF should be included in the analysis because it is incremental z If “no”, the CF should not be included in the analysis because it will occur anyway z If “part of it”, part of the CF should be included; the part that occurs because of the project z Example: the Lamp Project 7 Common Types of Cash Flows z Sunk costs – costs that have accrued in the past z Opportunity costs – costs of lost options z Side effects z Positive side effects – benefits to other projects z Negative side effects – costs to other projects z Changes in net working capital z Financing costs – neglect these costs for now; we want to know the cash flows created by the assets. For now, not concerned about who (creditors or shareholders) gets the cash flows z Taxes 8 Capital Budgeting Analysis 1. Find the relevant cash flows z Construct pro forma financial statements z Identify working capital needs; changes in NWC z Identify terminal value, if any z Begin and end the project in the same state! 2. Check for other effects: z Sunk costs, opportunity costs, side effects (externalities) 3. Exclude financing costs (for now!) 4. Find NPV for the project; other decision criteria 5. Apply the decision rule(s) 6. Consider additional analyses as appropriate z Scenarios, sensitivity analysis, effect of real options
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9 Pro Forma Statements and Cash Flow z Capital budgeting relies heavily on pro forma accounting statements, particularly income statements z Computing cash flows – refresher z Operating Cash Flow (OCF) = EBIT + depreciation – taxes z OCF = Net income + depreciation when there is no interest expense z Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC 10 Sample Project z Sell 50,000 cans of shark attractant per year at 4.00 / can z Cost of product: 2.50 / can z Project has a 3-year life z Required rate of return = 20% z Fixed costs for the project (actual cash costs, like SG&A) = 12,000 per year z
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6[1]. capital_budgeting_investment_decision - Capital...

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