2.Include the impact of the project on cash flows of other product lines •If a project is expected to affect cash flows of another project, include the expected impact on the cash flows of the other project in the analysis. FIN 300 - Cap Budget CF's 19
Estimating Cash Flows in Practice •Five General Rules for Incremental Cash-Flow Calculations 3.Include all opportunity costs •Benefits that could have been earned by choosing another project are a cost to the firm. 4.Ignore sunk costs •Sunk costs have already been incurred or committed to and will not be influenced by the project. FIN 300 - Cap Budget CF's 20
Estimating Cash Flows in Practice •Five General Rules for Incremental Cash-Flow Calculations 5.Include only after-tax cash flows •Incremental pre-tax cash flows earnings of a project only matter to the extent that they determine the free after-tax cash flows. FIN 300 - Cap Budget CF's 21
Adjusted FCF Calculations and NPV for the Performing Arts Center FIN 300 - Cap Budget CF's 22
Estimating Cash Flows in Practice •Nominal versus Real Cash Flows –Nominal dollars are what we typically think of. They represent the actual dollar amounts that we expect a project to generate in the future, without any adjustments for purchasing power. –When prices increase, a given nominal dollar amount will buy less than before. FIN 300 - Cap Budget CF's 23
Estimating Cash Flows in Practice •Nominal versus Real Cash Flows –Real dollars represent dollars stated in terms of constant purchasing power –Constant purchasing power is in terms of prices that existed in an earlier period •Constant purchasing power: “Last year this cost $50. Today it costs $60.” •The price increased by 20%. In real terms, $60 today has the buying power of $50 a year ago. FIN 300 - Cap Budget CF's 24
Estimating Cash Flows in Practice •Nominal versus Real Cash Flows –State all project cash flows as nominal dollars or state all project cash flows as real (inflation-adjusted) dollars •Value nominal cash flows using a nominal interest rate. •Value real cash flows using a real (inflation-adjusted) interest rate. FIN 300 - Cap Budget CF's 25
Estimating Cash Flows in Practice •Taxes and Depreciation –The progressive or marginal tax system used in the United States is one in which the proportion of income paid as taxes increases as the amount of taxable income increases FIN 300 - Cap Budget CF's 26
Estimating Cash Flows in Practice •Taxes and Depreciation –One especially important tax difference from a capital budgeting perspective is that the depreciation methods allowed by GAAP do not include some allowed by the IRS –The straight-line depreciation method illustrated in the performing arts center example is allowed by GAAP and is often used for financial reporting FIN 300 - Cap Budget CF's 27
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