chapter5 - 1 Chapter Five The Practice of Capital Budgeting...

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Unformatted text preview: 1 Chapter Five The Practice of Capital Budgeting MGMT 109 Managerial Finance Professor Lu Zheng Investment Projects Investment projects (capital investments) are the principle activity and value creator for most corporations. The process of project decision making is known as capital budgeting. What is a project (the finance perspective)? A set of cash flows and the associated timing of these flows. Three Steps to Capital Budgeting 1) Establishing the decision rule 2) Estimating cash flows (today) 3) Determining the appropriate discount rate 2 Estimating Cash Flows What are the relevant project cash flows? 1) Expected 2) Incremental 3) After-tax 4) Cash flows Expected Cash Flows A probability weighted average of cash flows across different scenarios/states of the world. State 1 2 3 CF 10 30 40 Prob. 0.25 0.5 0.25 E[CF] = (0.25)10 + (0.5) 30 + (0.25) 40 = 27.5 Incremental Cash Flows Establish the base case, i.e., what would the cash flows look like without the project. The incremental cash flows are the difference between the cash flows with the project and without the project. 3 Asking the Right Question You should always ask yourself Will this cash flow 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 will occur anyway If the answer is part of it, then we should include the part that occurs because of the project Sunk Costs Dont include sunk costs! What is a sunk cost? Paid in the past Non-recoverable Side Effects - Externalities Include side effects What is a side effect? An effect on the cash flows of other projects Example: erosion of income from other projects (cannibalization), externalities 4 Opportunity Costs Include opportunity costs What is an opportunity cost? A cash flow that will be foregone due to taking the project The use of an otherwise valuable asset Example: lost wages (MBA project) Example: Opportunity Costs A company owns a piece of land and is considering to build a factory. The current value of the land is $100,000. The factory is expected to operate for 8 years, at which point of time the value of the land is expected to be $180,000. Assume 12% cost of capital. What is the cost of land to the company? Opportunity cost = After-Tax Cash Flows If the IRS gets it, it doesnt count! Examples: depreciation, salvage value, operating losses 5 Cash Flows Cash flows not accounting income! Only Cash Flow is Relevant Cash Flows Cash flows to discount Depreciation is not a cash flow but affects taxation Do not forget investments in fixed assets Do not forget working capital requirements Separate financing from investing Do not forget continuing value Points to Watch Out For 6 Depreciation Depreciation is not a cash flow, but it affects taxation Revenue- Cost of Goods Sold- Depreciation- Selling, General & Admin.Selling, General & Admin....
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chapter5 - 1 Chapter Five The Practice of Capital Budgeting...

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