Net Present value &e Capital Budgeting
Chapter 7 Net Present Value & Capital Budgeting
Chapter Net Present Value and Capital Budgeting In this chapter we will describe how to actually do a net present value and discounted cash flows analysis for capital budgeting. The primary aim of this part is to describe how to identify a project's incremental cash flows. In this part we also discusses how to handle such as sunk costs, opportunity costs, financing costs, net working capital, and erosion
Chapter 7 Net Present Value and Capital Budgeting – In this chapter we will describe how to actually do a net present value and discounted cash flows analysis for capital budgeting. – The primary aim of this part is to describe how to identify a project’s incremental cash flows. – In this part we also discusses how to handle such as sunk costs, opportunity costs, financing costs, net working capital, and erosion
Chapter 7 Net Present value andr Capital Budgeting 7.1 Project cash flows: a first look 7.1.1 Relevant cash flows A relevant cash flows for a project is a change in the firm's overall future cash flow that comes about as a direct consequence of the decision to take that project. The relevant cash flow also called the incremental cash flows associated with the project. Incremental cash flows is the difference between a firm's future cash flows with a project or without the project
Chapter 7 Net Present Value and Capital Budgeting 7.1 Project cash flows: a first look 7.1.1 Relevant cash flows • A relevant cash flows for a project is a change in the firm’s overall future cash flow that comes about as a direct consequence of the decision to take that project. • The relevant cash flow also called the incremental cash flows associated with the project. • Incremental cash flows is the difference between a firm’s future cash flows with a project or without the project
Chapter Net Present Value and Capital Budgeting The concept of incremental cash flow is central to our analysis, so we will state a general definition and refer back to it The incremental cash flows for project evaluation consist of any and all changes in the firm's future cash flows that are a direct consequence of taking the project. 7.1.2 The stand-alone principle Once we identify the effect of undertaking the proposed project on the firms cash flows, we need only focus on the projects resulting incremental cash flows. this is called the stand-alone principle. The stand-alone principle refers to the rule that evaluation of a project based on the projects incremental cash flows
Chapter 7 Net Present Value and Capital Budgeting • The concept of incremental cash flow is central to our analysis, so we will state a general definition and refer back to it : The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project. 7.1.2 The stand-alone principle Once we identify the effect of undertaking the proposed project on the firm’s cash flows, we need only focus on the project’s resulting incremental cash flows.this is called the stand—alone principle. The Stand—alone principle refers to the rule that evaluation of a project based on the project’s incremental cash flows
Chapter Net Present Value and Capital Budgeting What the stand-alone principle says is that, once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of minifirm with its own future revenues and costs. its own assets and of course. its own cash flows We will then be primarily interested in comparing the cash flows from this minifirm to the cost of acquiring it. An important consequence of this approach is that we will be evaluating the proposed project purely on its own merits, in isolation from any other activities or projects
Chapter 7 Net Present Value and Capital Budgeting What the stand—alone principle says is that, once we have determined the incremental cash flows from undertaking a project, we can view that project as a kind of “minifirm”with its own future revenues and costs, its own assets, and of course, its own cash flows. We will then be primarily interested in comparing the cash flows from this minifirm to the cost of acquiring it. An important consequence of this approach is that we will be evaluating the proposed project purely on its own merits, in isolation from any other activities or projects
Chapter Net Present Value and Capital Budgeting 7.2 Incremental cash flows 7.2.1 Sunk costs A cost that has already been incurred and and can not be removed and therefore should not be considered in an investment decision 7.2.2 Opportunity cost The most valuable alternative that is given up if a particular investment is undertaken. 7.2.3 Side effects Erosion is the cash flows of a new project that come at the expense of all firms existing projects
Chapter 7 Net Present Value and Capital Budgeting 7.2 Incremental cash flows 7.2.1 Sunk costs A cost that has already been incurred and and can not be removed and therefore should not be considered in an investment decision. 7.2.2 Opportunity cost The most valuable alternative that is given up if a particular investment is undertaken. 7.2.3 Side effects • Erosion is the cash flows of a new project that come at the expense of all firm’s existing projects
Chapter Net Present Value and Capital Budgeting 7.2.4 Net working capital 7.2.5 Financing costs Some conclusions of incremental cash flows When we estimate cash flows on an incremental basis, we should learn by heart that Do not confuse average with incremental payoffs Include all incidental effects Do not forget working capital requirements Include opportunity costs. Forget sunk costs Beware of allocated overhead costs
Chapter 7 Net Present Value and Capital Budgeting 7.2.4 Net working capital 7.2.5 Financing costs Some conclusions of incremental cash flows When we estimate cash flows on an incremental basis, we should learn by heart that • Do not confuse average with incremental payoffs. • Include all incidental effects • Do not forget working capital requirements. • Include opportunity costs. • Forget sunk costs • Beware of allocated overhead costs
Chapter 7 Net Present value andr Capital Budgeting 7.3 Pro forma financial statements and project cash flows The first thing we need when we begin evaluating a proposed investment is a set of pro forma or projected financial statements. 7.3. 1 Getting started: pro forma financial statements Pro forma financial statements are those financial statements projecting future years operations
Chapter 7 Net Present Value and Capital Budgeting 7.3 Pro forma financial statements and project cash flows The first thing we need when we begin evaluating a proposed investment is a set of pro forma or projected financial statements. 7.3.1 Getting started: pro forma financial statements • Pro forma financial statements are those financial statements projecting future years’ operations
Chapter 7 Net Present Value and Capital Budgeting/ To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs We also need to know the total investment required including any investment in net working capitaL. Suppose we think we can sell something 50000cans per year at a price of $4.00per unit. It costs us about $2. 50per can, and a new product such as this one has only a three-year life. We require a 20% return on new products. The other factors are given like the next page
Chapter 7 Net Present Value and Capital Budgeting To prepare these statements, we will need estimates of quantities such as unit sales, the selling price per unit, the variable cost per unit, and total fixed costs. We also need to know the total investment required, including any investment in net working capital. Suppose we think we can sell something 50000cans per year at a price of $4.00per unit. It costs us about $2.50per can, and a new product such as this one has only a three-year life. We require a 20% return on new products. The other factors are given like the next page
Chapter Net Present Value and Capital Budgeting Projected income statements of special firm S ales $200000 Variables costs 125000 75000 Fixed costs 12000 Depreciation 30000 EBIT 33000 Taxes (34%) 11220 Net income 21780
Chapter 7 Net Present Value and Capital Budgeting Projected income statements of special firm Sales $200000 Variables costs 125000 75000 Fixed costs 12000 Depreciation 30000 EBIT 33000 Taxes (34%) 11220 Net income 21780
