Chapter 9: making capital investment decisions Flashcards
Relative Cash Flow
Include only cash flows that will occur if the project is accepted
Opportunity Costs, Side Effects/ Erosion, Tax effects
-Incremental cash flow for a project=
Corporate cash flow WITH the project MINUS corporate cash flow WITHOUT the project
Pro Forma Statements
-project future operations
Operating Cash Flow
OCF=EBIT + (Depreciation-Taxes)
OCF= NI + Depreciation (if no interest expense)
Net Working Capital
Current Assets- Current Liabilities
Depreciation Tax Shield
DT
D= depreciation expense
T=Marginal tax rate
Straight-Line Depreciation
D= (initial cost-salvage)/Number of years
After Tax Salvage
=Salvage-(salvage-book value)
Net Salvage Cash flow
= SP-(SP-BV) (T)
SP= selling price
BV=book value
T= corporate tax rate
Scenario Analysis
- examines several possible situations
- provides a range of possible outcomes
- Problems: considers only a few possible outcomes; assumes perfectly correlated inputs; focuses on stand-alone risk
Sensitivity Analysis
- shows how changes in an input variable affect NPV or IRR
- each variable is fixed except one
strengths: provides indication of stand-alone risk; identifies dangerous variables; gives some break even information
weaknesses: doesn’t reflect diversification
Disadvantages of Sensitivity & Scenario Analysis
Neither provides a decision rule
-no indication whether a project’s expected return is sufficient to compensate for its risk
Ignores diversification
-measures only stand-alone risk, which may not be the most relevant risk in capital budgeting
Managerial Options
Contingency Planning Option to Expand -expansion of existing product, new products, new geographic market Option to Abandon -contraction, temporary suspension Option to Wait Strategic Options
Capital Rationing
occurs when a firm or division has limited resources
- Soft rationing: limited resources are temporary
- Hard rationing: capital will never be available
