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Financial Management Chapter 10 IM 10th Ed

Financial Management Chapter 10 IM 10th Ed

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Published by Dr Singh

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Published by: Dr Singh on Mar 16, 2012
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Prof. Rushen Chahal
Cash Flows and Other Topicsin Capital Budgeting
Capital budgeting involves the decision-making process with respect to the investment infixed assets; specifically, it involves measuring the free cash flows or incremental cash flowsassociated with investment proposals and evaluating the attractiveness of these cash flowsrelative to the project's costs. This chapter focuses on the estimation of those cash flows basedon various decision criteria, and how to deal with capital rationing and mutually exclusive projects.
I.What criteria should we use in the evaluation of alternative investment proposals?A.Use free cash flows rather than accounting profits because free cash flowsallow us to correctly analyze the time element of the flows.B.Examine free cash flows on an after-tax basis because they are the flowsavailable to shareholders.C.Include only the incremental cash flows resulting from the investmentdecision. Ignore all other flows.D.In deciding which free cash flows are relevant we want to:1.Use free cash flows rather than accounting profits as our measurementtool.2.Think incrementally, looking at the company with and without the new project. Only incremental after tax cash flows, or free cash flows, arerelevant.3.Beware of cash flows diverted from existing products, again, looking atthe firm as a whole with the new product versus without the new product.
Prof. Rushen Chahal
4.Bring in working capital needs. Take account of the fact that a new project may involve the additional investment in working capital.5.Consider incremental expenses.6.Do not include stock costs as incremental cash flows.7.Account for opportunity costs.8.Decide if overhead costs are truly incremental cash flows.9.Ignore interest payments and financing flows.II.Measuring free cash flows. We are interested in measuring the incremental after-taxcash flows, or free cash flows, resulting from the investment proposal. In general,there will be three major sources of cash flows: initial outlays, differential cash flowsover the project's life, and terminal cash flows.A.Initial outlays include whatever cash flows are necessary to get the project inrunning order, for example:1.The installed cost of the asset2.In the case of a replacement proposal, the selling price of the oldmachine minus (or plus) any tax gain (or tax loss) offsetting the initialoutlay3.Any expense items (for example, training) necessary for the operationof the proposal4.Any other non-expense cash outlays required, such as increasedworking-capital needsB.Differential cash flows over the project's life include the incremental after-taxflows over the life of the project, for example:1.Added revenue (less added selling expenses) for the proposal2.Any labor and/or material savings incurred3.Increases in overhead incurred4.Changes in taxes.5.Change in net working capital.6.Change in capital spending.7.Make sure calculations reflect the fact that while depreciation is anexpense, it does not involve any cash flows.8.A word of warning not to include financing charges (such as interest or  preferred stock dividends), for they are implicitly taken care of in thediscounting process.
Prof. Rushen Chahal
C.Terminal cash flows include any incremental cash flows that result at thetermination of the project, for example:1.The project's salvage value plus (or minus) any taxable gains or lossesassociated with the project2.Any terminal cash flow needed, perhaps disposal of obsolete equipment3.Recovery of any non-expense cash outlays associated with the project, suchas recovery of increased working-capital needs associated with the proposal.III.Measuring the cash flows using the pro forma methodA.A projects free cash flows = project’s change in operating cash flows-change in net working capital-change in capital spendingBIf we rewrite this, inserting the calculations for the projects change inoperating cash flows (OCF), we get:A project’s free cash flows =Change in earnings before interest and taxes-change in taxes+ change in depreciation-change in net working capital-change in capital spendingC.In addition to using the pro forma method for calculating operating cash flows,there are three other approaches that are also commonly used. A summary of all the different approaches follows,D.OCF Calculation: The Pro Forma Approach:Operating Cash Flows = Change in Earnings Before Interest and Taxes -Change in Taxes + Change in DepreciationE. Alternative OCF Calculation 1: Add Back ApproachOperating Cash Flows = Net income + DepreciationE. Alternative OCF Calculation 2: Definitional ApproachOperating Cash Flows = Change in revenues - Change in cash expenses -Change in Taxes

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