Chapter10 - FIN3100: Chapter 10 Cash Flow Estimation...

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FIN3100: Chapter 10 Cash Flow Estimation
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Learning Objective Understand how to determine the relevant cash flows for a proposed investment
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Cash Flow Cash flow measures the actual inflow and outflow of cash, while profits represent an accounting measure of periodic performance. The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted. These cash flows are called incremental cash flows .
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Costs to Include There are some important things to keep track of: sunk costs opportunity costs erosion synergy gains changes in working capital requirements depreciation or cost recovery of assets
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Sunk Costs Expenses that have already been incurred, or that will be incurred, regardless of the decision to accept or reject a project. For example, a marketing research study exploring business possibilities in a region would be a sunk cost, since its expenditure has taken place prior to undertaking the project and will have to be paid whether or not the project is taken on. These costs, although part of the income statement, should not be considered as part of the relevant cash flows when evaluating a capital budgeting proposal.
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Opportunity Costs Costs that result from lost options. For example, if a firm decides to use an idle piece of equipment as part of a new business, the value of the equipment that could be realized by either selling or leasing it would be a relevant opportunity cost. These costs should be included.
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Erosion and Synergy Costs that arise when a new product or service competes with revenue generated by a current product or service offered by a firm. For example, a beverage firm markets a new product. Some of the revenues from the customers who would have purchased their other products will be lost and should therefore be accounted for in the incremental cash flows. On the other hand, sales of an existing product may
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Chapter10 - FIN3100: Chapter 10 Cash Flow Estimation...

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