336 Capital Budgeting Estimating Cash Flows

336 Capital Budgeting Estimating Cash Flows - Capital...

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Capital Budgeting: Estimating Cash Flows I. Estimating Cash Flows A. Rules to Follow: 1. Consider only the incremental cash flows: - Ignore sunk costs . - Consider the opportunity cost of assets being used. - Include side effects (erosion, cannibalism). 2. For replacement projects, focus solely on the changes in cash flows. 3. Ignore financing (interest costs); focus on operating cash flows. 4. Focus on after tax cash flows! 5. Include changes in net working capital as a cost in any period that it may occur. Addition (reduction) to NWC is a negative (positive) cash flow. B. The three-stage approach to estimating project cash flows: 1. Initial Investment Outlay : Usually negative 2. Operating cash flows : Net cash flows during project’s life 3. Terminal year cash flows : Final year adjustments C. A Closer Look at Net Working Capital How Changes in NWC Affect Cash Flow: An increase in any current asset (+NWC) is a cash outflow (-Cash) A decrease in any current asset (-NWC) is a cash inflow (+Cash) An increase in any current liability (-NWC) is a cash inflow (+Cash) A decrease in any current liability (+NWC) is a cash outflow (-Cash) II. Three Stage Approach for Estimating Cash Flows 1. Initial Investment cash flows : Usually negative Fin 336: Capital Budgeting: Estimating Cash Flows, p. 1
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- All initial costs necessary to bring a project up and running - Initial changes in net working capital (cash, AR, inventory) - Opportunity costs (alternative use for building, land, etc.) - If it’s a replacement project , you must consider: * Sale of original asset * Tax consequences of sale (book value vs selling price) 2. Annual cash flows : Net cash flows during project’s life - All after-tax cash flows from operations - Key Formula: OCF = (R-O-D)((1-t) +D -
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