Ross Westerfield Jordan Chapter 10 Fundamentals of 7TH EDITION Corporate Finance STANDARD EDITION Making Capital Investment Decisions 0
0 Chapter 10 Making Capital Investment Decisions
Chapter Outline Project Cash Flows:A First Look Incremental Cash Flows Pro Forma Financial Statements and Project Cash Flows More on Project Cash Flow Alternative Definitions of Operating Cash Flow Some Special Cases of Cash Flow Analysis
1 Chapter Outline n Project Cash Flows: A First Look n Incremental Cash Flows n Pro Forma Financial Statements and Project Cash Flows n More on Project Cash Flow n Alternative Definitions of Operating Cash Flow n Some Special Cases of Cash Flow Analysis
Key Concepts and Skills -Understand how to determine the relevant cash flows for various types of proposed investments Be able to compute depreciation expense for tax purposes Understand the various methods for computing operating cash flow
2 Key Concepts and Skills n Understand how to determine the relevant cash flows for various types of proposed investments n Be able to compute depreciation expense for tax purposes n Understand the various methods for computing operating cash flow
Relevant Cash Flows -The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted These cash flows are called incremental cash flows The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
3 Relevant Cash Flows n The cash flows that should be included in a capital budgeting analysis are those that will only occur if the project is accepted n These cash flows are called incremental cash flows n The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows
Asking the Right Question You should always ask yourself "Will this cash flow occur ONLY if we accept the project?" o If the answer is "yes",it should be included in the analysis because it is incremental ▣If the answer is“no”,it should not be included in the analysis because it will occur anyway If the answer is "part of it",then we should include the part that occurs because of the project
4 Asking the Right Question n You should always ask yourself “Will this cash flow occur ONLY if we accept the project?” q If the answer is “yes” , it should be included in the analysis because it is incremental q If the answer is “no” , it should not be included in the analysis because it will occur anyway q If the answer is “part of it” , then we should include the part that occurs because of the project
Common Types of Cash Flows Sunk costs costs that have accrued in the past Opportunity costs-costs of lost options Side effects Positive side effects -benefits to other projects Negative side effects costs to other projects ■( Changes in net working capital Financing costs Taxes 5
5 Common Types of Cash Flows n Sunk costs – costs that have accrued in the past n Opportunity costs – costs of lost options n Side effects q Positive side effects – benefits to other projects q Negative side effects – costs to other projects n Changes in net working capital n Financing costs n Taxes
Pro Forma Statements and Cash Flow ■ Capital budgeting relies heavily on pro forma accounting statements,particularly income statements a Computing cash flows-refresher Operating Cash Flow (OCF)=EBIT depreciation -taxes OCF Net income depreciation when there is no interest expense Cash Flow From Assets(CFFA)=OCF-net capital spending (NCS)-changes in NWC 6
6 Pro Forma Statements and Cash Flow n Capital budgeting relies heavily on pro forma accounting statements, particularly income statements n Computing cash flows – refresher q Operating Cash Flow (OCF) = EBIT + depreciation – taxes q OCF = Net income + depreciation when there is no interest expense q Cash Flow From Assets (CFFA) = OCF – net capital spending (NCS) – changes in NWC
Table 10.1 Pro Forma Income Statement Sales (50,000 units at $4.00/unit) $200,000 Variable Costs($2.50/unit) 125,000 Gross profit $75,000 Fixed costs 12,000 Depreciation($90,000 3) 30,000 EBIT $33,000 Taxes (34%) 11,220 Net Income $21,780 7
7 Table 10.1 Pro Forma Income Statement Sales (50,000 units at $4.00/unit) $200,000 Variable Costs ($2.50/unit) 125,000 Gross profit $ 75,000 Fixed costs 12,000 Depreciation ($90,000 / 3) 30,000 EBIT $ 33,000 Taxes (34%) 11,220 Net Income $ 21,780
Table 10.2 Projected Capital Requirements Year 0 1 2 3 NWC $20,000 $20,000 $20,000 $20,000 NFA 90,000 60,000 30,000 0 Total $110,000 $80,000 $50,000 $20,000 8
8 Table 10.2 Projected Capital Requirements Year 0 1 2 3 NWC $20,000 $20,000 $20,000 $20,000 NFA 90,000 60,000 30,000 0 Total $110,000 $80,000 $50,000 $20,000
Table 10.5 Projected Total Cash Flows Year 0 1 2 3 OCF $51,780 $51,780 $51,780 Change -$20,000 20,000 in NWC NCS -$90,000 CFFA -$110,00 $51,780 $51,780 $71,780 9
9 Table 10.5 Projected Total Cash Flows Year 0 1 2 3 OCF $51,780 $51,780 $51,780 Change in NWC -$20,000 20,000 NCS -$90,000 CFFA -$110,00 $51,780 $51,780 $71,780
