Fins5514_w04

Fins5514_w04 - Making Investment Decisions Mark...

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Making Investment Decisions Mark Humphery-Jenner
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Lecture Outline • Project Cash Flows: A First Look • Incremental Cash Flows • Pro Forma Financial Statements and Project Cash Flows • More about Project Cash Flow • Alternative Definitions of Operating Cash Flow • Some Special Cases of Discounted Cash Flow Analysis 10-2
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Key Concepts and Skills • Understand how to determine the relevant cash flows for various types of proposed investments • Understand the various methods for computing operating cash flow • Understand how to set a bid price for a project • Understand how to evaluate the equivalent annual cost of a project 10-3
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Relevant Cash Flows • The cash flows that should be included in a capital budgeting analysis are those that will only occur (or not occur) if the project is accepted • These cash flows are called incremental cash flows • The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows 10-4
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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 10-5
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Common Types of Cash Flows • Sunk costs – costs that have accrued in the past • Opportunity costs – costs of lost options • Side effects – Positive side effects – benefits to other projects – Negative side effects – costs to other projects • Changes in net working capital • Financing costs • Taxes 10-6
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Pro Forma Statements and Cash Flow • Capital budgeting relies heavily on pro forma accounting statements, particularly income statements • Computing cash flows – refresher – Operating Cash Flow (OCF) = EBIT + depreciation – taxes – OCF = Net income + depreciation (when there is no interest expense) – Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC 10-7
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Step 1: Generate Pro-forma balance sheet Sales (50,000 units at $4.00/unit) $200,000 Variable Costs ($2.50/unit) 125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT $ 33,000 Taxes (34%) 11,220 Net Income $ 21,780 10-8
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Step 2: project capital requirements Year 0 1 2 3 NWC $20,000 $20,000 $20,000 $20,000 NFA 90,000 60,000 30,000 0 Total $110,000 $80,000 $50,000 $20,000 10-9
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Fins5514_w04 - Making Investment Decisions Mark...

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