Ch09+Capital+Budgeting_h

Ch09+Capital+Budgeting_h - Chapter 9 MAKING CAPITAL...

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Chapter 9 MAKING CAPITAL BUDGETING DECISIONS C ASH F LOW C ONSIDERATIONS Relevant cash flows: Any changes in the firm’s future cash flows that are a direct consequence of undertaking a project. Stand-alone principle: A project can be evaluated in isolation, once we have identified all of the project’s incremental cash flows. A project can have its own little income statement and balance sheet. Sunk costs: Cash flows already paid or promised to be paid. Opportunity costs: Cash flows lost or foregone by taking one action rather than another. Would land, already owned by a firm but not being used, be “free” when considering the investment outlay of a plant to be built on it? Side effects: How does a project impact the firm’s other operations? Cannibalization (or erosion): 1
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P ROJECTING A P ROJECT S C ASH F LOWS Pro Forma Projection: A forecast Treat the project as a mini-firm (stand-alone project). Use only incremental cash flows (only the changes ). 1) Start by producing a pro-forma income statement (sales forecast and expenses forecast). ( DO NOT include INTEREST or any other FINANCIAL cash flows, such as loan payments). 2) Gather the relevant balance sheet information: Current assets required (inventory, accounts receivable) and long-term assets required (equipment). 3) Convert the accounting figures to CASH FLOW FROM ASSETS. Recall: Cash flow from assets= Operating Cash Flow + cash flow for NWC + cash flow for capital spending (with the correct signs) 4) Once you have identified the cash flow from assets, use capital budgeting techniques to make the accept / reject decision: Determine a discount rate and compute NPV. 2
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O PERATING C ASH F LOW (OCF) OCF = EBIT - Taxes + depreciation Interest expenses are NOT considered here! Depreciation (a noncash charge) boosts cash flows by shielding income from taxation. Deduct depreciation to determine EBIT. Add back depreciation to determine OCF. Depreciation tax shield : the increased cash flow created by depreciation Value of tax shield = Depreciation charge × tax rate Example: How depreciation affects taxes and OCF: the value of the depreciation tax shield. Tax rate = 30% Scenario 1 (No Depreciation) Scenario 2 ( with Depreciation) Sales $100,000 $100,000 - Costs 50,000 50,000 - Depreciation 0 20,000 EBIT 50,000 30,000 - Taxes 15,000 9,000 Oper profit after tax 35,000 21,000 + Depreciation 0 20,000 Operating Cash Flow $35,000 $41,000 Result: Operating cash flow was higher due to depreciation.
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