Comm298-Week9-Making_capital_investment_decisions-wit

Comm298-Week9-Making_capital_investment_decisions-wit -...

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Com298: Week 9 Making Capital Investment Decisions Learning Objectives: Focus on the following: Definition of project cash flows. Determining the relevant cash flows Alternative definitions of operating cash flows. Using tax shield approach in project analysis. Project Cash Flows Definition of project cash flows: Project cash flow 1
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= project operating cash flow - project additions to net working capital - project capital spending Definition of operating cash flow: Operating cash flow = EBIT + depreciation - taxes Example: Deriving operating cash flow Sales revenue = $912.0 Costs = 593.0 Depreciation = 135.0 EBIT = 184.0 Taxes @ 34% = 62.6 Net income = 121.4 OCF = EBIT + Depreciation - Taxes. = 184 + 135 – 62.6 = 256.4 General Guidelines to Derive the Relevant Cash Flows for a Project Incremental cash flows: The relevant cash flows are the incremental cash flows arising from the proposed new project. Sunk costs : are not relevant for the decision to 2
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accept or reject the project, they should be excluded from the cash flows of the project. Opportunity costs should be accounted for in the cash flows of the project. Positive side effects: benefits to other projects should be accounted for in the cash flow analysis. Negative side effects: called erosion or costs to other projects, should be deducted to reflect the lost cash flows on other lines. Financing costs should not be included in the cash flows of the project e.g. interest payments to creditors, dividends and principal repaid. Student Exercise A company owns a piece of land which it will use as a site for its new project. Cost of land = $2m. Current market value of land = $2.5m. The land needs upgrading at a cost of $50,000. Investment cost of project = $10m. Identify the sunk cost, the opportunity cost and the 3
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total initial investment cost of this project. Answer: Sunk cost = _________ Opportunity cost of the land = __________ Initial cost of the project =______________ Student Exercise Purdy’s sales of a new mint chocolate could bring in $100,000 and could boost sales of existing nut chocolates by $20,000. But it would result in the erosion of sales for milk chocolates by $10,000. What is the relevant sales cash flows figures ? Answer: Relevant net sales figure = ________________ 4
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Project Net Working Capital (NWC) Why consider project additions to net working capital ? At the initial stage of a project, there will be a need for some working capital to get the project off the ground. At the end of the project, some remaining working capital may still exist. By assumption, net working capital requirements
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Comm298-Week9-Making_capital_investment_decisions-wit -...

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