5_1Santikian_FBE 421_sp11_

5_1Santikian_FBE 421_sp11_ - FBE 421: Financial A nalysis...

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FBE 421: Financial Lecture 5 Project Cash Flows
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Lecture Outline Discounted Cash Flows and Project Valuation The Three-Step DCF Process Defining Investment Cash Flows Relevant Cash Flows Example: Frito Lay Conservative and Optimistic Cash Flows Equity Free Cash Flow vs. Project Free Cash Flow Forecasting Project Free Cash Flows Example: Lecion Electronics Corporation Valuing Investment Cash Flows Using NPV and IRR to Evaluate the Investment Mutually Exclusive Projects
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How Do We Value a Project? We can apply DCF valuation : The value of an investment is determined by the magnitude and the timing of the cash flows it is expected to generate. where the CF terms represent expected future cash flows by the investment and the r terms represent the discount rate. Discount rates = opportunity cost of capital i.e., the potential return that can be obtained from another investment with comparable risk (more on this soon) ... ) 1 ( 1 2 2 2 1 1 0 + + + + + = r CF r CF CF DCF
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The 3-Step DCF Process
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NPV Criteria Choose projects that create value for shareholders (NPV>0) Use DCF process to compute the NPV of the project
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Defining Investment Cash Flows 1) What cash flows are relevant to the valuation of a project or investment? 2) Are the cash flow forecasts either conservative or optimistic? 3) What is the difference between firm and project cash flows?
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Relevant Cash Flows (1) “Relevant” cash flows = impact valuation of the project Two important questions to ask to determine relevancy of cash flows: 1) Are the cash flows incremental to the project under consideration? 2) Do the cash flows represent sunk costs? Incremental Cash Flows Direct result of the acceptance of an investment The additional cash flows generated by the investment: 1) cash flows directly generated by the investment Projected revenues and costs of the new product 2) indirect effects on a firm’s other lines of business Example: potential cannibalization of other existing products True incremental cash flows = new product cash flows net
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Incremental Cash Flow Example When Frito-Lay evaluates a new salty snack product, they realize that a portion of the new product sales will come from the lost sales from existing products This challenge is common in mature firms with large market share Frito-Lay’s formal approach: Step 1: Estimate total revenue generated by product Step 2: Estimate percent of revenue that is true incremental revenue Step 3: Estimate the incremental cash flow Lime Doritos®: Highest risk of cannibalization Low incremental sales, most sales a result of reductions in existing product sales Baked Chip: Medium risk of cannibalization Higher percentage of the revenue considered as true incremental sales due to potential for additional store shelf space Natural Line: Lowest risk of cannibalization
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Relevant Cash Flows (2) Important
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This note was uploaded on 02/23/2011 for the course FBE 421 taught by Professor Plotts during the Spring '07 term at USC.

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5_1Santikian_FBE 421_sp11_ - FBE 421: Financial A nalysis...

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