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Week06_LectureNotes_6SlidesPerPage - LECTURES SO FARWEEKS...

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1 LECTURES SO FAR…WEEKS 4-5 Evaluation: Quantitative Analysis Step 1: Forecast cash flows • Free cash flows not accounting income • Incremental cash flows • Consistency principle – Inflation & Taxation • Consistency principle Inflation & Taxation Step 2: Determine risk of cash flows Step 3: Apply evaluation method • NPV, PI, IRR, MIRR, Payback, Discounted Payback, AAR 1 1 FINS1613_s2_2010_L6 FINS1613 BUSINESS FINANCE Lecture 6: Capital Budgeting Applications II Readings: RTBWJ Chapter 9 2 FINS1613_s2_2010_L6 LECTURE 6: LEARNING OBJECTIVES Understand how to quantitatively analyse different types of capital budgeting projects. Understand the qualitative aspects of evaluating capital budgeting projects. Understand how to incorporate cash flow risk in capital budgeting. Understand how to incorporate real options into capital budgeting. 3 3 FINS1613_s2_2010_L6 EVALUATING A PROJECT Steps in Evaluation using NPV : 1. Forecast cash flows 2. Estimate the opportunity cost of capital 3. Discount future cash flows by the opportunity cost of capital 4. Accept/reject the project based on whether NPV is positive/negative 4 4 FINS1613_s2_2010_L6 EVALUATING A PROJECT Forecasted cash flows can be split into 3 areas: 1. Initial investment outlay : the up-front cost of the project plus any increases in net operating working capital 2. Operating cash flows & NWC : incremental cash flows over the project’s economic life. 3. Terminal cash flows :cash flows which occur at theend of a project’s life other than the operating cash flows e.g. salvage value of fixed assets (adjusted for tax if necessary) and returned net operating working capital 5 5 FINS1613_s2_2010_L6 EVALUATING A PROJECT The net cash flows in each year of the project are determined as the sum of the cash flows in each of the areas above. These annua ne cash flows are then used in the NPV These annual net cash flows are then used in the NPV calculation. 6 6 FINS1613_s2_2010_L6
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2 EVALUATING AN EXPANSION PROJECT : AN EXAMPLE Consider an expansion project –An expansion project uses new assets to increase sales. Hence the incremental cash flows are the in-flows and out-flows the project creates. • Need to have detailed forecasts of all relevant cash flows. 7 7 FINS1613_s2_2010_L6 EVALUATING AN EXPANSION PROJECT : AN EXAMPLE A firm wishes to expand by producing solar-powered toy racing cars. – A new factory will be built. – New machinery will need to be purchased. – The project will produce/sell the cars for 4 years after which the factory and machinery will be sold. 8 8 FINS1613_s2_2010_L6 EVALUATING AN EXPANSION PROJECT : AN EXAMPLE The following are project’s forecasted cash flows (t=0): Factory Cost $20,000 Machinery cost $5,000 Net Operating Working Capital (NWC) $6,000 Units Sold (t=1 10 000 For simplicity, we will ignore inflation so prices/costs remain constant.
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This note was uploaded on 07/25/2011 for the course FINS 1613 taught by Professor Drkhshim during the Two '10 term at University of New South Wales.

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Week06_LectureNotes_6SlidesPerPage - LECTURES SO FARWEEKS...

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