FIN 3504 Chapter Notes - Chapter 10: Sunk Costs, Cash Flow, Opportunity Cost

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bronzeturtle979

4 Aug 2016

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In evaluating a proposed investment, we pay special attention to deciding what information is relevant to the decision at hand and what information is not. As we will see, it is easy to overlook important pieces of the capital budgeting puzzle. The effect of taking a project is to change the firm"s overall cash flows today and in the future. To evaluate a proposed investment, we must consider these changes in the firm"s cash flows and then decide whether they add value to the firm. The first (and most important) step, therefore, is to decide which cash flows are relevant. Because the relevant cash flows are defined in terms of changes in, or increments to, the firm"s existing cash flow, they are called the incremental cash flows associated with the project. The concept of incremental cash flow is central to our analysis, so we will state a general definition and refer back to it as needed:

Related Questions

An investment is acceptable if its NPV is _____. An investment is unacceptable if its NPV is ______. The NPV of an asset measures the ____ which accrues to the ____ of the firm if the asset is acquired. Thus, the use of the NPV rule is consistent with the financial manager's goal of maximizing the ____ of the firm's common stock.

A _____ is the impact that a given capital budgeting project might have on cash flows in another area of the firm. These changes in cash flows (are/are not) incremental cash flows for the project under construction

pearscorpion256

Assume you have just graduated from college with a degree in finance and you are trying to explain to your boss the importance of identifying and using the appropriate cash flows when you make financial decisions. He is considering investing in a project and he has identified the following cash flows and information that he considers relevant.

-Forecast net income for years 1 through 8 of $450,000 per year.

-Initial investment in equipment and facility of $2,200,000

-Value of equipment and facility at projectâs termination $200,000

-The equipment will be fully depreciated by the projectâs end. For simplicity assume equal amounts every year.

-The companyâs marginal tax rate is 15%

-Your boss expects to allocate 20% of his time to the new project and he makes $250,000 per year.

-The companyâs required return on the project is 10%.

-Your boss has not included any additional funds for net working capital.

-Your boss is basing his forecasts on the results from a product test market that the firm paid $245,000 to have conducted.

Please answer questions and show work.

1. Explain incremental cash flows to your boss and identify the main categories of incremental cash flows.

2. Identify the relevant cash flows in this project. Justify your answers.