Chap 5_Capital_Budgeting

Chap 5_Capital_Budgeting - Capital Budgeting Click to edit...

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M G M T 50 5, Fa ll 20 RWJ, Chapter 5-7 Click to edit Master subtitle style Capital Budgeting
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M G M T 50 5, Fa ll 20 RWJ, Chapter 5-7 Murali “Capital” refers to long-term funds. “Capital Budgeting” refers to decisions on how long-term funds are used to fund projects Intuitive: Manager chooses projects that maximize the “value” of (Revenue - Costs). This “value” is called “Net Present Value”, or NPV. Alternatively, Manager chooses projects that earn more than the cost of funds. cost of funds is called “Weighted Average Cost of Capital”. What is Capital Budgeting?
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M G M T 50 5, Fa ll 20 RWJ, Chapter 5-7 Murali Step 1: Project cash-flows from project. We often start with accounting numbers. Adjust these numbers to estimate after-tax cash-flows from project Step 2: Make sure that the cash-flows are incremental Incremental cash flows = Cash flow to firm with project – Cash flow to firm without project Step 3: Calculate Cost of Capital Use SML or other ways (from Chapters 9-12) to determine cost of capital invested in the project. The cost of capital should be adjusted for the risk of the project. Step 4: Compute NPV and other measures to make decisions How do we proceed?
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M G M T 50 5, Fa ll 20 RWJ, Chapter 5-7 Murali Estimate Revenues Estimate Costs Estimate Taxes Need Depreciation to compute taxes Estimate Investment Capital Expenditure Working Capital Recovery from sale of old assets Estimating Operating Cash-flow
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M G M T 50 5, Fa ll 20 RWJ, Chapter 5-7 Murali Estimating Project Cash-flows We need to project incremental cash-flows Cash-flows with project less cash-flows without project Sunk costs are not incremental CF. We only need to project operating cash-flows Financing cash-flows like interest, and its tax benefit, will be taken into account in the discount rate. We need to project after-tax cash-flows Taxes are based on accounting earnings. So, we start with accounting projections so as to estimate taxes. We then adjust it to reflect actual CF.
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M G M T 50 5, Fa ll 20 RWJ, Chapter 5-7 Murali Projecting cash-flows Projection into the future is always difficult. Use past experience Test Market Scenario analysis / Simulation Projecting future sales is likely the most critical. Variables such as COGS, is usually a function of sales (mostly variable costs).
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M G M T 50 5, Fa ll 20 RWJ, Chapter 5-7 Murali Capital-Budgeting decisions are long-term decisions . Only long-term cash-flows are relevant. Only incremental cash-flows are important to the analysis - not total cash flows . Consider a new project that is expected to generate $10m in sales. If
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Chap 5_Capital_Budgeting - Capital Budgeting Click to edit...

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