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Chapter 11 - Estimating Incremental Cash Flows Never...

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314 Estimating Incremental Cash Flows “Never underestimate the value of cold cash.” —Gregory Nunn Saving Money? Company X is a large multinational corporation with many facilities throughout the United States and the rest of the world. Employees at a variety of U.S. sites frequently are required to travel to the home office in Headquarters City. On a typical day there may be a dozen or more employees traveling to Headquarters City from any given satellite city site. Company X has many corporate jets at airports throughout the United States near the larger satellite cities. Senior executives routinely fly on these corporate jets when traveling to Headquarters City. Middle-level managers fly on commercial aircraft, usually located at a much greater distance from the workplace. The reason for this is that the department of the traveling employee is “billed” $800 if the corporate jet is used. This $800 expense goes into the financial report of that department, which goes to corporate headquarters. Managers can frequently find commercial airfares under $300 for employees traveling to Headquarters City. Because each department would rather be charged $300 a trip instead of $800 when reporting its financial performance, only a few of the most senior executives fly the corporate jets. This means that each corporate jet typically has a dozen empty seats for its daily flights to Headquarters City. It is clearly in the interest of each department manager to keep his or her expenses down. Is it in the interests of the stockholders to have mostly empty planes fly each day to Headquarters City? The cost of adding an additional
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315 © V.Leach ( http://www.fotolia.com/p/4594 ) Learning Objectives After reading this chapter, you should be able to: 1. Explain the difference between incremental cash flows and sunk costs. 2. Identify types of incremental cash flows in a capital budgeting project. 3. Explain why cash flows associated with project financings are not included in capital budgeting analysis. passenger, or 12 additional passengers, to a corporate jet is almost zero. A very small amount of additional fuel would be consumed. The stockholders would save $300 for each additional person who took an otherwise-empty seat on a corporate jet instead of flying on a commercial airline. Consider the interests of the department managers and those of the stockholders of Company X as you read Chapter 11. Chapter Overview In Chapter 10, we applied capital budgeting decision methods, taking the cash flow estimates as a given. In this chapter, we see how financial managers determine which cash flows are incremental and, therefore, relevant to a capital budgeting decision. We define incremental cash flows and distinguish incremental cash flows from sunk costs. We also examine how financial managers estimate incremental initial investment cash flows and incremental operating cash flows in the capital budgeting decision. Finally, we explore how the financing cash flows of a capital budgeting project are factored into the capital budgeting decision.
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