Chapter 10 Making Capital Investment Decisions

Topics: Depreciation, Cash flow, Net present value Pages: 14 (2625 words) Published: May 2, 2011
Key concepts and skills
Project Cash Flows
Relevant Cash Flows
The Stand-Alone Principle

Incremental Cash Flows
Sunk Costs
Opportunity Costs
Side Effects
Net Working Capital
Financing Costs
Other Issues

Pro Forma Financial Statements and Project Cash Flows
Getting Started: Pro Forma Financial Statements
Project Cash Flows
Projected Total Cash Flow and Value

More about Project Cash Flow
A Closer Look at Net Working Capital

Evaluating Equipment Options with Different Lives

Project Cash Flows

Relevant Cash Flows

Cash flows that occur (or don't occur) because a project is undertaken. Cash flows that will occur whether or not we accept a project are not relevant.

Incremental cash flows
Any and all changes in the firm's future cash flows that are a direct consequence of taking the project

Note: A project's cash flows imply changes in future firm cash flows and, therefore, in the firm's future financial statements. Below are a couple examples of possible projects that would suggest consideration of an incremental item.

1) The development of a plant on land currently owned by the company versus the same development on land that must be purchased. This example leads to a discussion of opportunity cost.

2) Consider the tax shelter provided by depreciation: What is the relevant depreciation effect if we replace an old machine with a three-year remaining life and $5,000 per year depreciation? Suppose the new machine will cost $45,000 and will be depreciated over a 5-year life with straight-line depreciation. The depreciation expense on the new machine would be $9,000 per year. Assume a tax rate of 40%. Therefore, the incremental depreciation expense for the first three years is $4,000, leading to a depreciation tax shield of $4,000(.4) = $1,600. The incremental depreciation tax shield for years 4 and 5 is $9,000(.4) = $3,600.

Problems: 1 and 2, pp. 327 – 328

The Stand-Alone Principle

Viewing projects as “mini-firms” with their own assets, revenues and costs allow us to evaluate the investments separately from the other activities of the firm.

Common Types of Cash Flows
Sunk Costs

A cash flow already paid or accrued. These costs should not be included in the incremental cash flows of a project. From an emotional standpoint, it does not matter what investment has already been made. We need to make our decision based on future cash flows, even if it means abandoning a project that has already had a substantial investment.

Example: A firm has a policy of paying the tuition bills for any of its newly hired managers who attend UWEC's MBA program on their own time. Two managers already taking MBA classes are assigned to develop a new product. Should their tuition costs be included in the project's cash flows? No! These costs are history, they're sunk!

Opportunity Costs

Any cash flows lost or forgone by taking one course of action rather than another. Applies to any asset or resource that has value if sold, or leased, rather than used.

Side Effects

With multi-line firms, projects often affect one another – sometimes helping, sometimes hurting. The point is to be aware of such effects in calculating incremental cash flows.

Erosion (or Cannibalism) – new project revenues gained at the expense of existing products/services.

Examples: Additional examples of side-effects associated with decisions can be useful. Here are some possibilities:

a) Whenever Kellogg's brings out a new oat cereal, it will probably reduce existing product sales.

b) McDonald's introduction of the Arch Deluxe had a substantial, and to a large extent unanticipated, impact on the sale of Big Macs. The internal analysts had assumed that a larger proportion of sales of the Arch Deluxe would come from new customers than actually occurred.

c) Whenever a university adds a new program, it needs to consider how many new students will come to...
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