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Cash Flows and Other Topics in Capital Budgeting

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Cash Flows and Other Topics in Capital Budgeting Chapter 10 Cash Flows in General Measure Incremental Cash Flows Measure cash flows that change if a project is undertaken Sunk cost is irrelevant Opportunity cost is relevant Do not include allocation of existing overhead

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slide1

Cash Flows and Other

Topics in Capital Budgeting

Chapter 10

cash flows in general
Cash Flows in General

Measure Incremental Cash Flows

  • Measure cash flows that change if a project is undertaken
  • Sunk cost is irrelevant
  • Opportunity cost is relevant
  • Do not include allocation of existing overhead
  • Do subtract lost sales of other products
  • Include cost savings as a positive cash flow.
cash flows in general3
Cash Flows in General
  • New Project vs. Replacement Project
    • New project – simply addition to company
    • Replacement – replace and existing old machine or plant.
  • Financing costs - Interest and Dividend payments. are not considered operating cash flows. Financing cost are used to discount the cash flows to find NPV,etc.
  • Only include CASH inflows and outflows.
estimating cash flows

0 1 2 3 N

Estimating Cash Flows

Three Types of Cash Flows

  • Initial Outlay

Initial Outlay

estimating cash flows5

0 1 2 3 N

Estimating Cash Flows

Three Types of Cash Flows

  • Initial Outlay
  • Operating (Differential) Cash Flows

Initial Outlay

Operating Cash Flows

estimating cash flows6

0 1 2 3 N

Estimating Cash Flows

Three Types of Cash Flows

  • Initial Outlay
  • Operating (Differential) Cash Flows
  • Terminal Cash Flow

Initial Outlay

Terminal Cash Flow

Operating Cash Flows

estimating cash flows7
Estimating Cash Flows

Initial Outlay

  • Cost of Assets
  • Installation and Shipping
  • Non-Expense Outlays (i.e. Working Capital)
  • Expense Outlays after tax (i.e. Training Expenses)
estimating cash flows8
Estimating Cash Flows

Initial Outlay

  • Cost of Assets
  • Installation and Shipping
  • Non-Expense Outlays (i.e. Working Capital)
  • Expense Outlays after tax (i.e. Training Expenses)

Only for Replacement Projects

  • Sale of Old Machine
estimating cash flows9
Estimating Cash Flows

Initial Outlay

  • Cost of Assets
  • Installation and Shipping
  • Non-Expense Outlays (i.e. Working Capital)
  • Expense Outlays after tax (i.e. Training Expenses)

Only for Replacement Projects

  • Sale of Old Machine
  • Taxes on Machine
estimating cash flows10
Estimating Cash Flows

Initial Outlay

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%.

estimating cash flows11
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

estimating cash flows12
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

estimating cash flows13
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

estimating cash flows14
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

4,000(1-0.40)

estimating cash flows15
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

estimating cash flows16
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

estimating cash flows17
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

–Taxes – 4,000

Tax rate x (Salvage Value-Book Value)

.4(10,000 – 0)

estimating cash flows18
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

–Taxes – 4,000

– 6,000

estimating cash flows19
Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

–Taxes – 4,000

– 6,000

Initial Outlay +49,400

estimating cash flows20

0 1 2 3 4 5

Estimating Cash Flows

Initial Outlay

Cost of Machine +48,000

Installation & Shipping 2,000

Working Capital 3,000

Training (after tax) 2,400

+55,400

Less: Sale of Old Machine

Salvage Value 10,000

–Taxes – 4,000

– 6,000

Initial Outlay +49,400

-49,400

estimating cash flows21
Estimating Cash Flows

Terminal Cash Flow

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Recover Working Capital +3,000

estimating cash flows22
Estimating Cash Flows

Terminal Cash Flow

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Recover Working Capital +3,000

Sell “New” Machine 15,000

estimating cash flows23
Estimating Cash Flows

Terminal Cash Flow

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Recover Working Capital +3,000

Sell “New” Machine 15,000

Tax on Sale -6,000

.4(15,000-0)

estimating cash flows24
Estimating Cash Flows

Terminal Cash Flow

Example:

Gasperini Corp. is considering replacing their old production machine with a new one. The cost of the new machine is $48,000; installation and delivery cost $2,000. Working Capital requirements on the new machine are $3,000 immediately, and training costs amount to $4,000. The old machine can be sold for $10,000; its book value is zero. Gasperini has a marginal tax rate of 40%. The new machine Gasperini Corp is considering buying will increase revenues by $5,000/yr and decrease costs by $8,000/ yr. They expect to use the machine for 5 years, and expect to sell it for $15,000 in 5 years. Assume Gasperini uses the Simplified Straight Line method to depreciate assets.

Recover Working Capital +3,000

Sell “New” Machine 15,000

Tax on Sale -6,000

Terminal Cash Flow +12,000

capital rationing
Capital Rationing
  • In large companies, many projects are evaluated each year
  • Management often imposes a limit that can be spent on new projects adopted during the year–Capital Rationing
  • In order to allocate scarce resources, choose the group of projects whose initial outlays are within the capital spending limit while at the same time maximizing NPV of the group of projects.
capital rationing26
Capital Rationing

Example

The following independent projects are subject to a

$100,000 capital budget.

Project IO NPV PI

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

All Projects have NPV > 0, PI > 1

capital rationing27

Project IO NPV PI

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital Rationing

Example

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

capital rationing28

Project IO NPV PI

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital Rationing

Example

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

5 90,000 6,000

capital rationing29

Project IO NPV PI

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital Rationing

Example

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,500

40,000 3,000

90,000 4,500

capital rationing30

Project IO NPV PI

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital Rationing

Example

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,500

40,000 3,000

90,000 4,500

1,3 & 4 50,000 1,500

30,000 2,500

20,000 1,000

100,000 5,000

capital rationing31

Project IO NPV PI

1 50,000 1,500 1.03

2 40,000 3,000 1.075

3 30,000 2,500 1.083

4 20,000 1,000 1.05

5 90,000 6,000 1.067

Capital Rationing

Example

Project

Combinations IO NPV

2, 3 & 4 40,000 3,000

+30,000 +2,500

+20,000 +1,000

90,000 6,500

5 90,000 6,000

1 & 2 50,000 1,500

40,000 3,000

90,000 4,500

1,3 & 4 50,000 1,500

30,000 2,500

20,000 1,000

100,000 5,000

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