L6 - Lecture 6 Making Capital Budgeting Decisions Should we...

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Lecture 6 Making Capital Budgeting Decisions Should we build this plant?
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6-2 Key Concepts and Skills Know how to determine a firm’s relevant cash flow from its pro forma financial statements Know how to determine a firm’s overall cost of capital Understand and apply investment critiria
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6-3 Lecture Outline Capital Budgeting Steps of Capital Budgeting Relevant Cash Flows Cost of Capital Investment Criteria
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6-4 What is Capital Budgeting? Long-term investment decisions and usually involve large expenditures. Analysis of potential additions to a company’s fixed assets. Very important to a company’s future cash flows and time of money valuations.
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6-5 Steps in Capital Budgeting Estimate the future cash flows relevant to the project. Assess the riskiness of the project. Determine the appropriate cost of capital. Make the decision based on several investment criteria. Payback Period Rule Net Present Value Internal Rate of Return
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6-6 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
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6-7 Asking the Right Question You should always ask yourself “Will this cash flow change 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 is not affected by the project If the answer is “part of it,” then we should include the part that occurs because of the project
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6-8 Common Types of Cash Flows Sunk costs – costs that have accrued in the past Opportunity costs – costs of lost options Side effects Positive side effects – benefits to other projects Negative side effects – costs to other projects Changes in net working capital Financing costs Taxes
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6-9 Relevant Cash Flows Ignore financing effects Dividends and interest expense should not be included in the analysis. Financing effects are taken into account by discounting cash flows at the cost of capital. Ignore sunk costs Consider opportunity costs Consider side effects The effect on other projects is an “externality.” Externalities can be positive (in the case of complements) or negative (substitutes).
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6-10 Pro Forma Statements and Cash Flow Capital budgeting relies heavily on pro forma accounting statements, particularly income statements Computing cash flows – refresher Cash Flow From Assets (CFFA) = Operating Cash Flow (OCF) – Net Capital Spending (NCS) – changes in Net Working Capital (NWC) OCF = EBIT + depreciation – taxes = NI + depreciation (if no interest expense) NCS = Ending net fixed assets – Beginning net fixed assets + Depreciation Changes in NWC = Ending NWC – Beginning NWC
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6-11 Proposed Project
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L6 - Lecture 6 Making Capital Budgeting Decisions Should we...

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