ActSc371_Lecture 18_Chapter 8 (Ross) -

ActSc371_Lecture 18_Chapter 8 (Ross) - - ActSc 371...

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Lecture 19 Chapter 8: NPV and Capital Budgeting (Corporate Finance by Ross et al.) ActSc 371 – Corporate Finance 1 Instructor: Dr. Lysa Porth 1
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Introduction Move beyond basic NPV problems and look at real-world applications of these techniques. How to use discounted cash flow (DCF) analysis and NPV in capital budgeting decisions. How to identify relevant cashflows of a project, including: Initial investment outlays Requirements for net working capital Operating cash flows Effects of depreciation and taxes Impact of inflation on interest rates Project’s discount rate Why inflation must be handled consistently in NPV analysis.
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Capital Budgeting A capital budgeting question is just an elaboration on an NPV question. In an NPV question, you are deciding whether to go ahead with a project or not by determining whether the present value of the positive cash flows are bigger than the present value of the negative cash flows. The capital budgeting question is just the same, except that you have to determine the cash flows before you can calculate their net present value . In a capital budgeting question, a few paragraphs of information will be given to you to pore over and determine what information is relevant, and what to do with the information that is.
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Remember, we want cash flows, not accounting income! There are many differences between earnings and cash flows. Example: firm buying a building for $100,000 today. The entire 100k is an immediate cash outflow, however, assuming straight-line depreciation over the next 20 years, only $5,000 is considered an accounting expense in the current year. Current earnings are therefore, only reduced by only $5,000. But, the entire $100,000 should be viewed as an immediate cash outflow for capital budgeting purposes. In addition, it is not enough to use cash flows. The only relevant information is information relating to incremental cash flows. An incremental cash flow is the extra cash flow that would exist ONLY if the project were to be accepted .
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To avoid common pitfalls, you must remember to take into account the following steps. Ignore Sunk Costs Sunk costs are things that have been paid for in the past. Sunk costs must always be ignored. Anything that has been paid for in the past is irrelevant to deciding whether to accept a project or not. This is because the money has been spent, and is gone. You can’t ask for your money back. TIP: cross out sunk costs as soon as you identify
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This note was uploaded on 12/16/2011 for the course ACSTC 371 taught by Professor Lisaporth during the Fall '11 term at Waterloo.

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ActSc371_Lecture 18_Chapter 8 (Ross) - - ActSc 371...

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