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IFM10 Ch13 Lecture

# IFM10 Ch13 Lecture - CHAPTER 13 Capital Budgeting...

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CHAPTER 13 Capital Budgeting: Estimating Cash Flows and Analyzing Risk 1

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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 3-year class. 3 Continued…

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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 Project’s incremental cash flow is: Corporate cash flow with the project Minus Corporate cash flow without the project. 5

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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

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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 firm’s 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

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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

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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? Nominal r > real r. The cost of capital, r, includes a premium for inflation. Nominal CF > real CF. This is because nominal cash flows incorporate inflation. If you discount real CF with the higher nominal r, then your NPV estimate is too low.

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