FINS5514S1Yr2010IncrementalCashFlowApproachSuppNotes

FINS5514S1Yr2010IncrementalCashFlowApproachSuppNotes -...

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Unformatted text preview: Supplementary Notes: Incremental Cash Flow Approach to Project Analysis * by Kyung Hwan Shim University of New South Wales Australian School of Business School of Banking & Finance for FINS 5514 S1 2010 March 23, 2010 * These notes are preliminary and under development. They are available for FINS 5514 S1 2010 students only and may not be distributed or used without the aurthors written consent. 1 Contents 1 Introduction 4 2 Accounting vs. Financial Variables. Use Real Cash Flows and Not Accounting Profits. 4 3 Estimate cash flows on an Incremental Basis 6 4 Common Sources of Cash Flows in Project Analysis 8 4.1 Purchase and Sale of Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 4.2 Operating Cash Flows excluding Arrears and Depreciation . . . . . . . . . . . . . . 9 4.3 Cash Flows from Depreciation of Assets . . . . . . . . . . . . . . . . . . . . . . . . 10 4.3.1 The Prime Cost Method to Depreciating Assets . . . . . . . . . . . . . . . . 11 4.3.2 The Diminishing Value Method to Depreciating Assets . . . . . . . . . . . . 11 4.3.3 Other Tax Rules Related To Assets Depreciation . . . . . . . . . . . . . . . 12 4.3.4 PV of Tax Shields from Depreciation of an Asset: Derivation of Formula . . 13 4.3.5 Recaptured Depreciation and Terminal Losses . . . . . . . . . . . . . . . . . 15 4.4 Investments in Net Working Capital . . . . . . . . . . . . . . . . . . . . . . . . . . 17 4.5 Sunk and Opportunity Costs, and Incidental Effects . . . . . . . . . . . . . . . . . 18 4.5.1 Sunk Costs are Irrelevant . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 4.5.2 Opportunity Costs are Relevant . . . . . . . . . . . . . . . . . . . . . . . . 19 4.5.3 Incidental Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 4.6 Other considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 4.6.1 Overhead costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 4.6.2 Nominal vs. Real Amounts . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 5 Putting it all together: Nutty Chocolates Mini Case 23 6 Assessing Project Risks 25 6.1 Sensitivity Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 6.1.1 NPV Break-Even Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 6.1.2 Operating Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28 6.2 Scenario Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 6.3 Managerial Flexibility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 2 6.4 Monte Carlo Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 3 1 Introduction The NPV investment criterion is the most important investment evaluation method available and it should be the one used most widely in capital budgeting. While the concept of discounting future cash flows to present value is intuitive, applying NPV in real applications is a very complex...
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This note was uploaded on 03/30/2011 for the course FIN 5514 taught by Professor Jaffe during the Three '11 term at University of New South Wales.

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FINS5514S1Yr2010IncrementalCashFlowApproachSuppNotes -...

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