CSUF FIN 320 - Cash Flows and Other Topics in Capital Budgeting

Chapter 10Cash Flows and Other Topics in Capital BudgetingChapter ObjectivesIncremental Cash FlowsCapital BudgetingSunk CostsOpportunity CostsOverhead CostsInterest Payments and Financing CostsFree Cash Flow CalculationsInitial Cash OutlayDifferential Flows over a Project’s LifeTerminal Cash FlowMeasuring the Operating Cash FlowsSteps in Calculating Operating Cash FlowsChange in Net Working CapitalChange in Capital SpendingDifferential Free Cash FlowsOptions in Capital BudgetingRisk in Capital Budgeting DecisionsProject Standing Alone RiskContribution-to-Firm RiskSystematic RiskRiskRisk and Capital BudgetingMeasurement of RiskBetaPowerPoint PresentationChapter 10Chapter 10Cash Flows and Other Topics Cash Flows and Other Topics in Capital Budgetingin Capital BudgetingChapter ObjectivesChapter ObjectivesGuidelines to measure cash flowsCalculate a project’s benefits and costs—or free cash flowsOptions or flexibility in capital budgetingMeasure measure of risk in capital budgeting decisionsAcceptability of a new project using the risk-adjusted discount method of adjusting for riskSimulation for imitating the performance of a projectDifficulties of a multinational firm in estimating cash flowsIncremental Cash FlowsIncremental Cash FlowsOnly incremental after-tax cash flows matterMust consider incremental expensesCapital BudgetingCapital BudgetingConsider:–Incremental Costs/expenses–Opportunity Costs–Incremental overhead costsIgnore:–Sunk Costs–Interest payments and financing cash flowsSunk CostsSunk CostsCash flows that have already taken place are called sunk costsCosts that have been sunk into a project and can not be undoneOpportunity CostsOpportunity CostsOpportunity cost cash flows should reflect net cash flows that would have been received if the project were rejectedOverhead CostsOverhead CostsMust include incremental overhead costs or costs that were incurred as a result of the projectInterest Payments and Interest Payments and Financing CostsFinancing CostsInterest charges associated with raising funds for a project are not a relevant cash outflow. Required rate of return implicitly accounts for the cost of raising funds to finance a new project.Free Cash Flow CalculationsFree Cash Flow CalculationsRelevant cash flows1. Initial cash outlay2. Differential flows over the project’s life3. Terminal cash flowInitial Cash OutlayInitial Cash OutlayImmediate cash outflow necessary to purchase the asset and put it in operating orderMay include:–Purchase cost–Installation–Shipping/Freight–Set-up cost–Non-expense cash outlays—increased working-capital requirementsDifferential Flows over a Differential Flows over a Project’s LifeProject’s LifeIncremental after-tax cash flows resulting form the project being consideredAny increase in interest payments incurred as a result of issuing bonds to finance the project will not be includedAdjustments for the incremental change in taxes should be includedChanges in net working capital should be includedTerminal Cash FlowTerminal Cash FlowFlows associated with the project’s terminationMay include:–Salvage value of the project plus or minus–Any taxable gains or losses associated with the saleMeasuring the Operating Measuring the Operating Cash FlowsCash FlowsProject’s change in operating cash flowsAfter tax savings or earnings that result from the new project–New sales or cost savings offset by any increased expenses—on an after-tax basis–Include any increases in overheadChange in sales – change in costs – change in taxesSteps in Calculating Operating Steps in Calculating Operating Cash FlowsCash Flows1. Earnings before interest and taxes with and without the project2. Subtract the change in taxes (ignore interest expense)3. Add back depreciationChange in Net Working Change in Net Working CapitalCapitalAdditional investment in working capital minus any additional short-term liabilities that were generatedChange in Capital SpendingChange in Capital SpendingInclude any changes in capital spending as a result of the projectDifferential Free Cash FlowsDifferential Free Cash FlowsChanges in earnings before interest and taxes – less – Change in taxes – less – Change in depreciation – less – Change in net working capital – less – Change in Capital SpendingOptions in Capital BudgetingOptions in Capital BudgetingValue in flexibility1. Option to delay a project2. Option to expand a project3. Option to abandon a projectRisk in Capital Budgeting Risk in Capital Budgeting DecisionsDecisionsProject Standing alone riskContribution to firm riskSystematic riskProject Standing Alone RiskProject Standing Alone RiskA project’s risk ignoring the fact that much of the risk will be diversified away as the project is combined with other projects and assetsContribution-to-Firm RiskContribution-to-Firm RiskAmount of risk that the project contributes to the firm as a whole; considers the fact that some of the project’s risk will be diversified away as the project is combined with the firm’s other projects and assets.Systematic RiskSystematic RiskRisk of the project from the viewpoint of a well-diversified shareholder; This measure takes into account that some of the risk will be diversified away as the project is combined with the firm’s other projects and in addition, some of the remaining risk will be diversified away by the shareholders as they combine this stock with other stocks in their portfolios.RiskRiskTheoretically, the only risk of concern to shareholders is systematic riskIn reality, the possibility of bankruptcy makes a project’s contribution-to-firm risk a relevant risk measure in addition to systematic riskRisk and Capital BudgetingRisk and Capital BudgetingRisk-adjusted discount rates – Investors demand higher returns for more risky projects.As the risk of a project increases, the required rate of return is adjusted upward.Present Value of a project is calculated at the higher, risk adjusted rateMeasurement of RiskMeasurement of RiskEstimating risk of a project can be difficult. Historical stock return data relates to an entire firm, rather than a specific project or division. Risk must be estimated. Options to estimate risk include:Accounting BetaPure Play MethodSimulationScenario