FIN504_PowerPoint_Slides_10

FIN504_PowerPoint_Slides_10 - FIN 504: Financial Management...

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FIN 504: Financial Management Lecture 10: Cash Flow Analysis
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2 FIN 504: Financial Management Topics Two General Principles Factors in Cash Flow Analysis Capital Rationing Mutually Exclusive Projects
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3 FIN 504: Financial Management Two General Principles Principle One: Use Increments. The Incremental Approach to Cash Flow Analysis Principle Two: Use Real Cash Flows. Real versus Accounting Cash Flows
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4 FIN 504: Financial Management The Incremental Approach The Incremental Approach to Cash Flow Analysis The ‘incremental’ approach is to analyze how real cash flows change as the result of a new project, i.e., what is the change in the value. The alternate view is to look at averages, i.e., what is the new average value.
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5 FIN 504: Financial Management The Incremental Approach Your firm is considering the development of a new division to add to the two current divisions. Consider the following overhead costs and how that cost should be allocated to the new division: Cost Before After Average Increment Furniture $10,000 $12,000 Software $9,000 $9,000 Insurance $4,000 $6,000
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6 FIN 504: Financial Management The Incremental Approach The first possibility would be to average the new costs among the three divisions and apply that average to the new division. For some accounting purposes this may be the appropriate method: Cost Before After Average Increment Furniture $10,000 $12,000 $4,000 Software $9,000 $9,000 $3,000 Insurance $4,000 $6,000 $2,000
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7 FIN 504: Financial Management The Incremental Approach An alternate possibility would be to apply to the new division the change in costs , i.e., the increment, associated with developing the new division: Note : We normally think of an ‘increment’ as a positive addition, but in this usage it could be a negative amount (though that would be unusual). Cost Before After Average Increment Furniture $10,000 $12,000 $4,000 $2,000 Software $9,000 $9,000 $3,000 $0 Insurance $4,000 $6,000 $2,000 $2,000
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8 FIN 504: Financial Management The Incremental Approach In cash flow analysis, we always use the increment as the relevant cash flow. When determining whether or undertake a project, we must know how the change will affect the total value (not the average value). Cost Before After Average Increment Furniture $10,000 $12,000 $4,000 $2,000 Software $9,000 $9,000 $3,000 $0 Insurance $4,000 $6,000 $2,000 $2,000
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FIN 504: Financial Management Real versus Accounting Cash Flows In our analysis of cash flows we must always be careful to use only ‘real’ cash flows. Unfortunately, there is an ambiguity in this use of ‘real’. Earlier we used the term ‘real’ in the real versus nominal distinction when discussing inflation. This is a completely different use of the term
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This note was uploaded on 06/29/2011 for the course FIN 525 taught by Professor Dloncar during the Spring '11 term at University of Baltimore.

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FIN504_PowerPoint_Slides_10 - FIN 504: Financial Management...

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