Chapter 11 FIN

Chapter 11 FIN - Chapter 11 Guidelines for Capital...

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Chapter 11 Guidelines for Capital Budgeting Use Free Cash Flows Rather than Accounting Profits The firm receives and is able to reinvest free cash flows, whereas accounting profits are shown when they are earned rather than when the money is actually in hand Free cash flows correctly reflect the timing of benefits and costs, that is, when money is received, when it can be reinvested, and when it must be paid out Think Incrementally What new free cash flows will the company as a whole receive if the company takes on a given project? Incremental after-tax free cash flows: the funds that the firm receives and is able to reinvest, as opposed to accounting profits, which are shown when they are earned rather than when the money is actually in hand Beware of Cash flows diverted from existing products In determining the free cash flows associated with the proposed project, we should consider only the incremental sales brought to the company as a whole. Look for Incidental or Synergistic Effects In the case of GM, it is the cash flow that comes from any GM sale that would not have occurred if a customer had not visited a GM showroom to see a Volt. Working in Working – Capital Requirements Working capital requirements are considered a free cash flow event though they do not leave the company. Generally, they are tied up over the life of the project. Consider Incremental Expenses Just as cash inflows from a new project are measured on an incremental basis, expenses, or cash outflows, should also be measured on an incremental basis. Remember that sunk costs are not incremental cash flows The manager asks two questions: Will this cash flow occur if the project is accepted/will this cash flow occur if the project is rejected?
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Chapter 11 - Yes to the first question and no to the second = incremental cash flow As a rule any cash flows that are not affected by the accept/reject criterion should not be included in capital budgeting analysis. Account for Opportunity Costs Opportunity cost cash flows should reflect the net cash flows that would have been received if the project under consideration were rejected. Decide if overhead costs are truly incremental cash flows Main question to be answered: Are incremental cash flows associated with the project and relevant to capital budgeting Ignore Interest payments and financing flows If accepting a project means we have to raise new funds by issuing bonds, the interest charges associated with raising funds are not a relevant cash outflow. Why? Because when we discount the incremental cash flows back to the present at the required rate of return, we are implicitly accounting for the cost of raising funds to finance the new project. An Overview of the Calculations of a Project’s Free Cash Flows
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Chapter 11 FIN - Chapter 11 Guidelines for Capital...

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