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Unformatted text preview: Chapter 8, 9, 10 Notes, Questions, and Answers 1 Chapter 8 Notes 1.1 Capital Budgeting categories: 1. Replacement projects. 2. Expansion projects. 3. New products and services. 4. Regulatory, safety, and environmental projects. 1.2 Principals of Capital Budgeting. 1. Timing of cash flows is crucial. Time Value of Money 2. Incremental Cash Flows. 3. Cash flows are analyzed on an aftertax basis. 4. Financing costs are ignored. 5. Cash flows are not net income. 1.3 Capital budgeting concepts. 1. A sunk cost is one that has already been incurred. 2. An opportunity cost is what a resource is worth in its nextbest use. 3. Externality is the effect of an investment on other things besides the investment itself. 4. Independent versus mutually exclusive. 1 1.4 Capital budget procedures NPV Payback Period Profitability Index IRR 1.5 Drawbacks of Payback Does not take into account time value of money ignores cash flows after payback. Projects with shorter paybacks may have lowest NPV 1.6 Pitfalls of IRR Borrowing or Lending Multiple Rates of Return Mutually Exclusive. Differing Cash flow patterns and Scale. Investment Timing You may purchase a computer anytime within the next five years. While the computer will save your company money, the cost of computers continues to decline. If your cost of capital is 10% and given the data listed below, when should you purchase the computer? 2 2 Chapter 9 Notes 1. Initial Outlay: Outlay = FCInv + NWCInv (1) where FCINV=investment in new fixed capital. NWINV=investment in net working capital. 2. Annual aftertax operating cash flow: CF = ( S C D )(1 T ) + D (2) or CF = ( S C )(1 T ) + T * D (3) where S=Sales C=cash operating expenses D=depreciation charge T=taxes 3. Terminal year aftertax nonoperating cash flow: TNOCF = SALT + NWInvT ( SalTBT ) (4) where SALT=cash proceeds from sale of fixed capital BT=Book value of fixed capital on termination date. 3 3 Chapter 10 notes Risk is the measure of the dispersion of outcomes. In this case we measure the riskiness of a project by the dispersion of NPVs or IRRs. Sensitivity analysis, scenario analysis, and simulation analysis are population risk analysis methods. These risk measures depend on the variation of the project cash flows. 1. Sensitivity Analysis  Analysis of the effects on project profitability of changes in sales, costs, etc. 2. Scenario Analysis  Project analysis given a particular combination of assumptions. 3. Simulation Analysis  Estimation of the probabilities of different possible outcomes....
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 Spring '09
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