Chapter 10 - Making Capital Investment Decisions Flashcards
What is the general principle of a relevant cash flow?
Relevant cash flow for a project is the change in the firm’s overall future cash flows as a result of that decision
How are relevant cash flows defined?
In terms of changes in cash flows, therefore called incremental cash flows
What is the stand alone principle?
Evaluation of a project based on the project’s incremental cash flows
What is a sunk cost?
A cost that we have already paid or incurred the liability to pay
We exclude sunk costs from our analysis
What is an opportunity cost?
The most valueable alternative that is given up if a particular investment is undertaken
We exclude opportunity costs from our analysis
What is erosion?
The portion of cash flows of a new project that come at the expense of a firm’s existing operations
What are side effects?
When a project’s effects have side, or spillover effects both good and bad that affect other parts of their operations
How does Net Working Capital play into capital budgeting?
The firm supplies working capital at the beginning and recovers it toward the end
How do Financing Costs play into analyzing a proposed investment?
We do not include interest paid or any other financing costs such as dividends or principal repaid, because we are interested in the cash flow generated by the assets from the project.
Its not that they’re unimportant but they’re a part of a different analysis as in this case were only concerned with NPV
How does Inflation play into analysis?
Given that nominal rates include an adjustment for expected inflation, cash flow estimates must also be adjusted for inflation.
What is capital cost allowance (CCA)?
Depreciation for tax purposes, not necessarily the same as depreciation under IFRS; depreciation method under Canadian tax allowing for the accelerate write off of property under various classification
How do government activities affect capital budgeting analysis
Various levels of government offer incentives to promote certain types of capital investment.
Since these change a project’s cash flows, they must be factored into capital budgeting analysis
Are we interested in pre or post-tax cash flows?
Post tax, as paying taxes is definitely a relevant cash outflow
Why do we not consider interest paid when making a Capital Investment analysis?
Interest paid is a component of cash flow to creditors, not a cash flow from assets
What do we need when we start evaluating a proposed investment?
Set of projected financial statements
What simplifying assumptions do we make when calculating cash flows?
We use straight-line depreciation as opposed to capital cost allowance.
We also assume that a full year’s depreciation can be taken in the first year.
Construct the example so the project’s market value equals its book cost when it is scrapped
What are pro forma financial statements?
Financial statements projecting future years’ operations
What are the three components of cash flows from assets?
- Operating cash flow
- Capital spending
- Net Working Capital
What is the equation for Project cash flow?
+ Project operating cash flow
- Project additions to net working capital
- Project capital spending
What is the equation for Operating Cash flow?
EBIT
+ Depreciation
- Taxes
= EBID
What are the three components that make up a project’s cash flow?
+ Operating cash flow
- Project additions to net working capital
- Project Capital Spending
If we had sales of 500 but our accounts receivable rose by $30 over the same time period what does this mean?
The $30 increase tells us that sales exceeded collections by $30, we have yet to receive $30 so Cash inflow is 500-30= $470
What is the equation for cash flow?
Cash flow = Cash inflow - Cash outflow
What is another way to calculate Cash flow and what does it tell us?
Cash flow = Operating cash flow - Change in NWC
Including NWC in our calculations has the effect of adjusting for the discrepancy between accounting sales and costs and actual cash receipts and payments
Operating Cash Flow (OCF)
= EBIT + D - Taxes
or
= EBIT * (1-Tc) + D
= Project net income + Depreciation
What is the top-down approach for OCF
OCF = Sales - Costs - Taxes
= 1500 - 700 - 80 = $720
Tax Shield Approach
OFC = (S-C) * (1-Tc) + D*Tc
