Final Exam Study Guide Notes

Final Exam Study Guide Notes - Final Exam Study Guide...

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Final Exam Study Guide Guidelines for Capital Budgeting, A Philosophy for Decision Making: 1. Use cash flows rather than accounting profits a. Principle – cash, not profits, is king b. Depreciation is the problem c. True timing of benefits is what’s important 2. Think Incrementally a. Principle – Incremental Cash Flows, It’s only what changes that counts b. Micro economic way of thinking – “It’s only what changes that counts” 3. Beware of cash flows diverted from existing products 4. Look for Incidental or Synergistic Effects 5. Work in Working Capital Requirements a. Inventory – part of the initial outlay, recapture when the project is terminated 6. Consider Incremental Expenses a. Training, sales training, Re-Engineering 7. Remember that Sunk Costs are not incremental cash flows 8. Account for opportunity cost a. The cost you assign to any asset you own should be its most profitable alternative 9. Decide if overhead costs are truly incremental cash flows a. Administrative costs 10. Ignore interest payments and Financing flows a. When we discount cash flows back to present we account for “cost of money” and if we subtracted out interest than we would count it again Measuring the Cash Flows Our interest is only in the incremental, or differential after-tax cash flows, for the company as a whole that are attributable to the proposed investment The importance of considering incremental cash flows to the company as a whole cannot be over emphasized 1. Initial Outlays a. Installed cost of assets b. Working capital requirements c. After tax expense items (training/installation/re-engineering) d. If a replacement project, sales value of old machine (+- taxes) 2. Estimating differential cash flows a. Added revenues less expensive Project Ranking and Capital Rationing 1. Importance of project ranking: Why not just take all projects with a NPV >= 0, PI >= 1.0, IRR >= K? a. Why you might accept a project with NPV <0 a.i. Real Options: Value created by project flexibility a.ii. Mutually exclusive projects: Acceptance of one project means rejection of another
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a.iii. Capital Rationing: A limit on capital spending 2. Real Options: Allowing for adjustments we can make in the project after it is accepted a. Option to expand b. Option to abandon c. Option to Delay (Timing Options) d. Real life example: Toyota and Honda initially lost money on hybrid cars Capital Rationing 1. We have implicitly been saying that the size of the capital budget is determined by the supply of available proposals 2. If constraint imposed a. Positive NPV projects are rejected b. How do you deal with projects that aren’t divisible 3. Since the firm always has an opportunity to raise additional finds in market, why would capital rationing ever exist? a.
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Final Exam Study Guide Notes - Final Exam Study Guide...

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