Capital budgeting: further issues
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Table of Contents
1. Components of NPV calculations
1.1 Free cash flows, not accounting income
1.2 Sunk costs
1.3 Opportunity costs
1.4 Side effects
1.5 Working capital
1.6 Company tax
1.7 Finance charges
1.8 Incremental cash flows
1.9 Inflation
2. Risk analysis in capital budgeting
3. Projects with unequal lives
4. Real option value consideration in capital budgeting
2

1. Components of NPV calculations
•
To include
–
Use free cash flows, not accounting income
–
Ignore sunk costs
–
Include opportunity costs
–
Include side effects
–
Include working capital
–
Include taxation
–
Ignore finance charges
(interest and loan repayments)
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Example 5.1
Compare accounting income and free cash flow for a two
‐
year
project using a machine that costs $100m and yields EBDIT of $53m
& $65m in years 1 & 2. Depreciation is on a straight
‐
line basis, and
the corporate tax rate is 30%
_______________________________________________
Step 1: Calculate the net incomegenerated by the project
:
Year
1
2
EBDIT
53
65
Assuming cost
of capital = 10%
NPV=$1.9m
1. Components of NPV calculations – 1.1 Free cash flows
1.1 Free cash flows, not accounting income
4
Footnote 1 in
p143 is
incorrect
Less depreciation
50
50
Taxable income
3
15
Less tax (30%)
0.9
4.5
Net income
2.1
10.5