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Unformatted text preview: 12-1 a. Cash flow, which is the relevant financial variable, represents the actual flow of cash. Accounting income, on the other hand, reports accounting data as defined by Generally Accepted Accounting Principles (GAAP). b. Incremental cash flows are those cash flows that arise solely from the asset that is being evaluated. For example, assume an existing machine generates revenues of $1,000 per year and expenses of $600 per year. A machine being considered as a replacement would generate revenues of $1,000 per year and expenses of $400 per year. On an incremental basis, the new machine would not increase revenues at all, but would decrease expenses by $200 per year. Thus, the annual incremental cash flow is a before-tax savings of $200. A sunk cost is one that has already occurred and is not affected by the capital project decision. Sunk costs are not relevant to capital budgeting decisions. Within the context of this chapter, an opportunity cost is a cash flow that a firm must forgo to accept a project. For example, if the project requires the use of a building that could otherwise be sold, the market value of the building is an opportunity cost of the project. c. Net operating working capital changes are the increases in current operating assets resulting from accepting a project less the resulting increases in current operating liabilities, or accruals and accounts payable. A net operating working capital change must be financed just as a firm must finance its increases in fixed assets. Salvage value is the market value of an asset after its useful life. Salvage values and their tax effects must be included in project cash flow estimation. d. The real rate of return (rr), or, for that matter the real cost of capital, contains no adjustment for expected inflation. If net cash flows from a project do not include inflation adjustments, then the cash flows should be discounted at the real cost of capital. In a similar manner, the IRR resulting from real net cash flows should be compared with the real cost of capital. Conversely, the nominal rate of return (rNOM) does include an inflation adjustment (premium). Thus if nominal rates of return are used in the capital budgeting process, the net cash flows must also be nominal. used in the capital budgeting process, the net cash flows must also be nominal....
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This note was uploaded on 12/11/2010 for the course FINANCE FI515 taught by Professor Fi during the Fall '09 term at Keller Graduate School of Management.
- Fall '09