Chapter 14 Cash Flow Estimation and Capital Budgeting Decisions Notes

14.1 General Guidelines for Capital Expenditure Analysis

•marginal or incremental cash flows additional cash flows that result from budgeting decisions, generated by new projects

•sunk costs costs that have already been incurred, cannot be recovered, and should not influence current decisions

•opportunity costs cash flows that must be forgone as a result of an investment decision

•externalities the consequences that result from an investment that may benefit or harm unrelated third parties

14.2 Estimating and Discounting Cash Flows

The Initial After-Tax Cash Flow (CF

0

)

•initial after-tax cash flow (CF

0

) the total cash outlay required to initiate an investment project, including the change in net

working capital and associated opportunity costs, which may affect the firm’s cash flow, but cannot be expensed for tax purposes

•capital cost (C

0

) all costs incurred to make an investment operational, such as machinery installation expenses, land-clearing

costs, and so on; these can be depreciated for tax purposes; different from initial after-tax cash flow

•CF0 = C

0

+ ∆NWC

0

+ OC

Expected Annual After-Tax Cash Flows (CF

t

)

•expected annual after-tax cash flows (CF

t

) the cash flows that are estimated to occur as a result of the investment decision,

comprising the associated expected incremental increase in after-tax operating income and any incremental tax savings (or

additional taxes paid) that result from the initial investment outlay

Two Ways to Determine Cash Flows after Capital Cost Allowance

Before-tax operating income (before depreciation)

– CCA

Taxable Income

– Taxes payable

After-tax income

+ CCA (non-cash expense)

Net cash flow

Before-tax operating income (before depreciation)

– Taxes payable on operating income

After-tax operating income

+ CCA tax savings

Net cash flow

•CF

t

= CFBT

t

(1 – T) + CCA

t

(T) where CFBT

t

= cash flow before taxes (i.e., incremental pre-tax operating income),

CCA

t

= the CCA expense for year t, T = the firm’s marginal (or effective) tax rate

Ending (or Terminal) After-Tax Cash Flows (ECF

n

)

•ending (or terminal) after-tax cash flow (ECF

n

) the total cash flow that is generated in the terminal year of a project, aside

from that year’s expected after-tax cash flow; the estimated salvage value of the asset

•salvage value (SV

n

) the estimated sale price of an asset at the end of its useful life

•ECF (with Tax Implications)

n

= SV

n

+ ∆NWC

n

– [(SV

n

– C

0

) × T] – [(SV

n

– UCC

n

) × T]

•generally, capital gains are rare for depreciable capital assets because most large firms will have several assets in a given CCA

pool, and the pool will remain open after the asset is sold—as a result, the asset cost and UCC will usually be greater than the

salvage value of any particular asset, so capital gains, terminal losses, and CCA recapture will not happen

•ECF

n

= SV

n

+ ∆NWC

n

14.3 Sensitivity to Inputs

Sensitivity Analysis

•sensitivity analysis examination of how investment’s NPV changes as value of different inputs are changed, one input at time

•this type of analysis allows firms to determine which of their estimates are the most critical in the final decision

•obviously, the most critical estimates require the greatest amount of scrutiny from the firm

•scenario analysis analysis of how investment’s NPV changes in response to varying scenarios in terms of 1 or more estimates

•it is also informative to vary the discount rate used in the NPV calculations, because this variable is hard to estimate precisely

and can change substantially through time as market, industry, and company conditions change

•it often makes sense to vary more than one input variable at a time, because it allows us to account for interactions among the

variables and for the fact that many of them can related to external variables

•real option valuation (ROV) assessment that recognizes firms respond to unlike circumstances and change operating features

Real Option Valuation (ROV)

•ROV places great weight on the flexibility involved in a firm’s operations

•decision tree a schematic way to represent alternative decisions and the possible outcomes

NPV Break-Even Analysis

www.notesolution.com

## Document Summary

14. 1 general guidelines for capital expenditure analysis: marginal or incremental cash flows additional cash flows that result from budgeting decisions, generated by new projects. Two ways to determine cash flows after capital cost allowance. Cft = cfbtt (1 t) + ccat (t) Ccat = the cca expense for year t, t = the firm"s marginal (or effective) tax rate where cfbtt = cash flow before taxes (i. e. , incremental pre-tax operating income), 9: consider the effect of all project interdependencies on cash flow estimates, treat inflation consistently. This harks back to comparing like with like: discount nominal cash flows with nominal. Ignore intangible considerations. discount rates, and real cash flows with real discount rates: undertake all social investments required by law, estimate the future cash flows associated with potential investments. These cash flows include 3 categories: initial cash flow, the expected annual after-tax cash flows, and the ending cash flow. o o o.