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Chapter 10 IM 10th Ed

Chapter 10 IM 10th Ed - CHAPTER 10 Cash Flows and Other...

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CHAPTER 10 Cash Flows and Other Topics in Capital Budgeting CHAPTER ORIENTATION Capital budgeting involves the decision-making process with respect to investment in fixed assets; specifically, it involves measuring the free cash flows or incremental cash flows associated with investment proposals and evaluating the attractiveness of these cash flows relative to the project's costs. This chapter focuses on the estimation of those cash flows based on various decision criteria, and how to deal with capital rationing and mutually exclusive projects. CHAPTER OUTLINE I. What criteria should we use in the evaluation of alternative investment proposals? A. Use free cash flows rather than accounting profits because free cash flows allow us to correctly analyze the time element of the flows. B. Examine free cash flows on an after-tax basis because they are the flows available to shareholders. C. Include only the incremental cash flows resulting from the investment decision. Ignore all other flows. D. In deciding which free cash flows are relevant we want to: 1. Use free cash flows rather than accounting profits as our measurement tool. 2. Think incrementally, looking at the company with and without the new project, only incremental after tax cash flows, or free cash flows, are relevant. 3. Beware of cash flows diverted from existing products, again, looking at the firm as a whole with the new product versus without the new product. 245
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4. Bring in working capital needs. Take account of the fact that a new project may involve the additional investment in working capital. 5. Consider incremental expenses. 6. Do not include stock costs as incremental cash flows. 7. Account for opportunity costs. 8. Decide if overhead costs are truly incremental cash flows. 9. Ignore interest payments and financing flows. II. Measuring free cash flows. We are interested in measuring the incremental after-tax cash flows, or free cash flows, resulting from the investment proposal. In general, there will be three major sources of cash flows: initial outlays, differential cash flows over the project's life, and terminal cash flows. A. Initial outlays include whatever cash flows are necessary to get the project in running order, for example: 1. The installed cost of the asset 2. In the case of a replacement proposal, the selling price of the old machine plus (or minus) any tax gain (or loss) offsetting the initial outlay 3. Any expense items (for example, training) necessary for the operation of the proposal 4. Any other non-expense cash outlays required, such as increased working-capital needs B. Differential cash flows over the project's life include the incremental after-tax flows over the life of the project, for example: 1. Added revenue (less added selling expenses) for the proposal 2. Any labor and/or material savings incurred 3. Increases in overhead incurred 4. Changes in taxes.
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