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Unformatted text preview: CHAPTER 13 Capital Budgeting: Estimating Cash Flows and Analyzing Risk 1 Topics Estimating cash flows: Relevant cash flows Working capital treatment Inflation Risk Analysis: Sensitivity Analysis, Scenario Analysis, and Simulation Analysis 2 Proposed Project Data $200,000 cost + $10,000 shipping + $30,000 installation. Economic life = 4 years. Salvage value = $25,000. MACRS 3year class. 3 Continued Project Data (Continued) Annual unit sales = 1,250. Unit sales price = $200. Unit costs = $100. Net operating working capital: NOWC t = 12%(Sales t+1 ) Tax rate = 40%. Project cost of capital = 10%. 4 Incremental Cash Flow for a Project Projects incremental cash flow is: Corporate cash flow with the project Minus Corporate cash flow without the project. 5 Treatment of Financing Costs Should you subtract interest expense or dividends when calculating CF? NO. We discount project cash flows with a cost of capital that is the rate of return required by all investors (not just debtholders or stockholders), and so we should discount the total amount of cash flow available to all investors. They are part of the costs of capital. If we subtracted them from cash flows, we would be double counting capital costs. 6 Sunk Costs Suppose $100,000 had been spent last year to improve the production line site. Should this cost be included in the analysis? NO. This is a sunk cost. Focus on incremental investment and operating cash flows. 7 Incremental Costs Suppose the plant space could be leased out for $25,000 a year. Would this affect the analysis? Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project. A.T. opportunity cost = $25,000 (1  T) = $15,000 annual cost. 8 Externalities If the new product line would decrease sales of the firms other products by $50,000 per year, would this affect the analysis? Yes. The effects on the other projects CFs are externalities. Net CF loss per year on other lines would be a cost to this project. Externalities will be positive if new projects are complements to existing assets, negative if substitutes. 9 What is the depreciation basis? 10 Basis = Cost + Shipping + Installation $240,000 Annual Depreciation Expense (000s) Year % X (Initial Basis) = Depr. 1 0.33 $240 $79.2 2 0.45 108.0 3 0.15 36.0 4 0.07 16.8 11 Annual Sales and Costs Year 1 Year 2 Year 3 Year 4 Units 1250 1250 1250 1250 Unit Price $200 $206 $212.18 $218.55 Unit Cost $100 $103 $106.09 $109.27 Sales $250,000 $257,500 $265,225 $273,188 Costs $125,000 $128,750 $132,613 $136,588 12 Why is it important to include inflation when estimating cash flows?...
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This note was uploaded on 02/13/2012 for the course FINA 4080 taught by Professor Mary during the Spring '11 term at Toledo.
 Spring '11
 mary

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