Chap010s

Chap010s - How to Make Good Capital Investment Decisions?...

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How to Make Good Capital Investment Decisions? Chapter Ten 1
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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 2
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Asking the Right Question You should always ask yourself “Will this cash flow occur 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 will occur anyway If the answer is “part of it”, then we should include the part that occurs because of the project 3
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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 (No!) Taxes 4
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Pro Forma Statements and Cash Flow Capital budgeting relies heavily on pro forma accounting statements, particularly income statements Computing cash flows Operating Cash Flow (OCF) = EBIT + depreciation – taxes In this chapter we will use: OCF = Net income + depreciation because we do not care about the interest expense Cash Flow From Assets (CFFA or FCF) = OCF – net capital spending (NCS or CAPEX) – changes in NWC 5
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Example We can sell 50,000 cans of shark attractant per year at a price of $4 a can. It costs us $2.50 a can to make. The fixed costs such as rent etc. will amount to $12,000 per year. The project will last for 3 years. We require a 20% rate of return.
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Chap010s - How to Make Good Capital Investment Decisions?...

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