chp 10 - Making Capital Investment Decisions Chapter Ten...

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Making Capital Investment Decisions Chapter Ten
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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 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
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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
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Common Types of Cash Flows Sunk costs – costs that have accrued in the past ( don’t include) Opportunity costs – costs of lost options( include) Side effects ( only the part due to project) Positive side effects – benefits to other projects Negative side effects – costs to other projects Changes in net working capital ( Include
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Pro Forma Statements and Cash Flow Capital budgeting relies on pro forma accounting statements Cash Flow From Assets ( CFFA): the total net cash flow per period associated with a project. Cash Flow From Assets has three components: Operating Cash Flow ( OCF ): regularly generated cash flows from the ongoing activities of the project. Income statements. ( sales) Changes in Net Working Capital ( NWC ): cash flows associated with cash on hand to smooth the current accounts. Balance sheet. Net Capital Spending ( NCS ): cash flows associated with the fixed assets of the project. Balance sheet. At Each Point in Time: ! CFFA = OCF – ΔNWC– NCS !
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3 Methods for Computing OCF Bottom-Up Approach Works only when there is no interest expense OCF = NI + depreciation Top-Down Approach OCF = Sales – Costs – Taxes Tax Shield Approach *** use when no income statement OCF = (Sales – Costs)(1 – T) +
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Pro Forma Balance Sheet Year 0 1 2 3 NWC Change NWC $40K 40 $40K $40K $40K -40 Net Fixed Assets NCS $60K 60 outflow $40K $20K 0 Total $100K $80K $60K $40K
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Pro Forma Income Statement Sales (100,000 units at $2.00/unit) $200,000 Variable Costs ($.75/unit) 75,000 Gross profit $125,000 Fixed costs 10,000 Depreciation 20,000 EBIT $ 95,000 Taxes (34%) 32,300 Net Income $ 62,700
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Projected Cash Flows Year 0 1 2 3 OCF 82,700 82,700 82,700 -ΔNWC -40,000 40,000 -NCS -60,000 0 =CFFA -100,000 82,700 82,700 122,700
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More on NWC Why do we have to consider changes in NWC separately? GAAP requires that sales be recorded on the income statement when made, not when cash is received GAAP also requires that we record cost of goods sold when the corresponding sales are made, regardless of whether we have actually paid our suppliers yet Finally, we have to buy inventory to support sales although we haven’t
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Depreciation The depreciation expense used for capital budgeting should be the depreciation
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chp 10 - Making Capital Investment Decisions Chapter Ten...

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