chap12 - Chapter12 1 BUDGETING Overview 2...

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CASH FLOW ESTIMATION AND OTHER ISSUES IN CAPITAL  BUDGETING Chapter 12 1
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Overview Cash Flow Estimation New or Expansion Project Other Cash Flow Estimation Issues Replacement Project (Web App 12B) Mutually Exclusive Projects with Unequal Lives (Web App 12F) 2
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Capital Budgeting Steps For a potential project: 1. Forecast the project cash flows. 2. Estimate the cost of capital 3. Discount the future cash flows at the cost of  capital. 4. Find NPV of project = PV of future cash flows –  required investment, and accept if NPV > 0. 3
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Forecast Project Cash Flows 0 1 2 3 4 5 n 6 . . . Terminal Cash flow Annual Cash Flows Initial outlay 4
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Cash Flow Estimation Need to estimate  incremental after tax incremental after tax   cash flows cash flows   that the project is expected to generate. General form:  Cash Flow = Incremental Net Income  + Depreciation Other “special” cash flows Initial costs Extra ending or terminal cash flows at the end of the project’s  expected useful life.  5
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Incremental Cash Flows IMPORTANT IMPORTANT Ask yourself this question Would the cash flow still exist if the project does  not exist? If yes, do not include it in your analysis. If no, include it. 6
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Karsten Ping Golf: New Project CF Analysis As an analyst at MAD Inc. you have been asked to work with a client seeking capital budgeting advice, Ping Golf. Ping is considering making a new line of over-sized irons aimed at mid to high handicap golfers (known as mere mortal golfers or most of the people who play golf). These new irons would be called the Ping Kings, and would have a 3-year product life. Ping has already researched and designed these new golf clubs. Ping has given MAD Inc. the following information in order for you to estimate the project’s cash flows. 7
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Ping cash flow information Ping has already spent $300,000 to research and design the Ping Kings. Ping will need to buy $4,000,000 in new manufacturing equipment plus $500,000 in shipping and installation costs, which would be depreciated using 3-year class MACRS depreciation. At the end of the project’s 3-year life, Ping estimates they can sell this equipment for $800,000. 8
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Ping cash flow information (cont) Ping will also need $700,000 in additional net working capital at the beginning of the project. Ping estimates they can sell 10,000 sets of Ping Kings in year 1, 15,000 sets in year 2, and 9,000 in year 3. They also estimate they can sell the Ping Kings for $640 a set in years 1 & 2, but they will only be able to sell them for $540 a set in year 3. Variable costs will be $350 a set for all three years and Ping also expects to have $300,000 in fixed manufacturing costs annually for this project.
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