Chapter 10 – More Capital BudgetingGuidelinesMore GuidelinesMeasuring Costs and BenefitsInitial OutlayDifferential Cash FlowsTerminal Cash FlowRisk in Capital BudgetingFord Motor Co. ApproachChapter 10 – More Capital Budgeting•Key Sections:•Guidelines for cash flows•Classifications of cash flows–Explain why interest and depreciation not included•Are different discount rates needed?Guidelines•What will happen if the project is not carried out?•Use after-tax cash flows, not accounting profits•Only incremental cash flows count–Look at whole firm with and without project–Consider: sales captured from competitors, synergies and cannibalizationMore Guidelines•Work in working capital requirements•Incremental expenses – training, rearrangement•Cash flows not affected by sunk costs•Opportunity costs – give up something•Are overhead costs incremental?•Ignore interest expenseMeasuring Costs and Benefits•Initial outlays – fully installed cost, less sale of old property and tax effect•Differential cash flows – increased revenues/savings; adjusted for incremental tax effects; interest is excluded•Terminal cash flows – cleanup, salvage, working capital recapture5Initial OutlayPurchase price $30Shipping 2Installation 3Employee training 2Tax on sale of old machine 1Increased inventory 5 Total outflows 43Sale of old machine - 15Initial outlay 286Differential Cash FlowsReduced salaries $10Reduced fringe 1Reduced defects 5Increased maintenance -4Increased depreciation NANet savings 12Less: tax on net savings -3Annual cash flow 97Terminal Cash FlowSalvage Value $12Tax impact (salvage/book) -1Cleanup/rearrangement -2Reduced inventory 3Terminal cash inflows +12Risk in Capital Budgeting•Risk – potential variability in cash flows–Uncertain outcome but can apply judgmental probabilities•Risk adjusted discount rate – adjusted upward to compensate for risk; lowers NPV•IRR – cutoff rate increasedFord Motor Co. Approach“Normally, all investment proposals are expected to generate an after-tax, time-adjusted rate of return [= IRR] of at least __%. Proposals with higher than normal risk are expected to generate commensurately higher returns. For a number of overseas areas, the minimum return is higher than
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