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Chapter 11
Cash Flows and Capital Budgeting
Learning Objectives
1.
Explain why incremental aftertax free cash flows are relevant in evaluating a
project and calculate them for a project.
2.
Discuss the five general rules for incremental aftertax free cash flow calculations
and explain why cash flows stated in nominal (real) dollars should be discounted
using a nominal (real) discount rate.
3.
Describe how distinguishing between variable and fixed costs can be useful in
forecasting operating expenses.
4.
Explain the concept of equivalent annual cost and use it to compare projects with
unequal lives, decide when to replace an existing asset, and calculate the opportunity
cost of using an existing asset.
5
.
Determine the appropriate time to harvest an asset.
I.
Chapter Outline
11.1
Calculating Project Cash Flows
•
All of the cash flow estimates are forwardlooking.
A.
Incremental AfterTax Free Cash Flows
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The cash flows we discount in an NPV analysis are the
incremental aftertax
free cash flows
, which refers to the fact that these cash flows reflect the
amount by which the firm’s total aftertax free cash flows will change if the
project is adopted. See Equation 11.1:
o
FCF
Project
= FCF
Firm with project
– FCF
Firm without project
•
The term
free cash flows (FCF)
refers to the fact that the firm is free to
distribute these cash flows to creditors and stockholders because these are the
cash flows that are left over after a firm has made necessary investments in
working capital and longterm assets.
B.
The FCF Calculation
•
Referring to 11.2, which is a more detailed version of 11.1:
FCF = [(Revenue – Op Exp – D&A) x (1 –
t
•
We first compute the incremental cash flow from operations (CF Opns),
which is the cash flow that the project is expected to generate after all
operating expenses and taxes have been paid.
•
We then subtract the incremental capital expenditures (Cap Ex) and
incremental additions to working capital (Add WC) required for the project to
obtain FCF.
•
The FCF is therefore a measure of the aftertax cash flows from operations
over and above what is necessary to make any required investments.
•
The idea that we can evaluate the cash flows from a project independently of
the cash flows for the firm is known as the
standalone principle
. It is
another way of saying that we can treat the project as if it is a standalone firm
that has its own revenue, expenses, and investment requirements.
C.
Cash Flows from Operations
•
Note that the incremental cash flow from operations, CF Opns, equals the
incremental net operating profits after tax (NOPAT) plus the incremental
associated with the project.
•
We exclude interest expenses when calculating NOPAT because the cost of
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This note was uploaded on 04/01/2012 for the course BUSINESS 100 taught by Professor Bens during the Spring '12 term at FIU.
 Spring '12
 bens
 Accounting

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