FNCE10002 Lecture Notes - Lecture 5: Retained Earnings, Net Present Value, Weighted Arithmetic Mean
19 Jun 2018
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Principles of Finance
Lecture 5: Capital Budgeting II
Issues in cash flow estimations
1. Timing of cash flows
The exact timing of project cash flows can affect the valuation of a project. The simplifying assumption that
we use is that the net cash flows are received at the end of a period.
2. Financing charges
Cash outflows that are relation to how a project is to be financed is not included in the analysis.
The valuation of the project is dependent on how it will be financed.
The discount rate used to represent the , and the rate of return required by debtholders and other security
holders.
Financing costs are not used in the cash flows because it results in their being double counted.
3. Incremental cash flows
Only cash flows that change if the project is accepted are relevant in evaluating a project
Cannibalization (lost sales in existing products)
Sunk costs
These costs are not included as they have been incurred in the past and will not be affected by the
project’s acceptance or rejection
Allocated costs
Overhead costs allocated by management to firm’s divisions
These costs do not vary with the decision and are usually ignored
Examples are administrative costs incurred by head office and allocated to divisions
4. Taxes and tax effects
Tax needs to be included where they influence the net cash generated by the project. Taxes have three
main effects on net cash flows
i. Corporate income tax
ii. Depreciation tax shield
iii. Taxes on disposal of assets
5. Corporate income tax
Corporate taxes should be included as a cash outflow.
6. Depreciation tax savings or depreciation tax shield
Depreciation itself is not an expense and is excluded form net cash flows. However, depreciation does
affect net cash flows because it reduces the taxes payable due to the depreciation tax shield.
7. Disposal or salvage value of assets
Disposal or salvage of assets needs to be considered after taxes.
i. Taxes are payable when the asset is disposed for more than its book value
ii. A tax saving occurs when an asset is sold for less than its book value as the cost can be offset
against taxable income.
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Where R= revenue, OC = operating cost and D= depreciation …
The incremental net after tax cash flows are:
Separating the after-tax residual or salvage value we get
Inflation and Capital Budgeting
It is important to be consistent with the treatment of inflation. For nominal cash flows, use a nominal
discount rate. For real cash flows, use a real discount rate. The Fisher relationship gives:
The Weighted Average Cost of Capital
WACC () is the benchmark required rate of return used by a firm to evaluate its investment opportunities.
The discount rate used to evaluate projects of similar risk to the firm. It will consider how a firm finances its
investments (debt vs equity). The WACC depends on:
i. The market value of alternative sources of funds
ii. The market costs associated with the sources of these funds
iii. Qualitative factors (adjustments for inflation, taxes)
Estimating the WACC
Four main steps involved in estimating WACC:
1. Identify financing components
find more resources at oneclass.com
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Document Summary
Issues in cash flow estimations: timing of cash flows. The exact timing of project cash flows can affect the valuation of a project. The simplifying assumption that we use is that the net cash flows are received at the end of a period: financing charges. Cash outflows that are relation to how a project is to be financed is not included in the analysis. The valuation of the project is dependent on how it will be financed. The discount rate used to represent the , and the rate of return required by debtholders and other security holders. Financing costs are not used in the cash flows because it results in their being double counted. Only cash flows that change if the project is accepted are relevant in evaluating a project. These costs are not included as they have been incurred in the past and will not be affected by the project"s acceptance or rejection.
