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  1. Project Cash Flows: A First Look
    1. Relevant Cash Flows (52.0K) Only incrementalcash flows (KEY TERM) are important for decision-making. Any cash flow that exists regardless of whether or not a project is undertaken is notrelevant.
    2. The Stand-Alone Principle According to this principle, every project should be viewed as a "minifirm," i.e., as an asset that could be valued in a free market.
  2. Incremental Cash Flows
    1. Sunk Costs are costs that have already been incurred and cannot be recouped and, therefore, should not be considered in an investment decision. (Definitions of this and other financial terms can be found at http://www.investorwords.com.)
    2. Opportunity Costs are benefits one gives up to undertake an investment. Click here (KEY TERM) for the economic definition.
    3. Side Effects Project side effects are any additional results of undertaking a project, whether favorable or unfavorable.
    4. Net Working Capital (KEY TERM) represents an additional cost associated with an investment.
    5. Financing Costs are not included explicitly in our cash flow calculations because we are only interested in measuring the cash flow generated by the project assets. Where do we take financing costs into account? CONCEPT CHECK
    6. Other Issues Two key points: (1) only incremental, after-tax cash flows are relevant, and (2) cash flows should be measured when they actually occur, not when they accrue, in an accounting sense.
  3. Pro Forma Financial Statements and Project Cash Flows (09007)
    1. Getting Started: Pro Forma Financial Statements are used to project future years' operations. These statements are adjusted to reflect the effects of the proposed investment project.
    2. Project Cash Flows
      • Project Cash Flow = Project Operating Cash Flow - Project Change in Net Working Capital - Project Capital Spending
      • Project Operating Cash Flow = Earnings before Interest and Taxes + Depreciation - Taxes
      • Project Net Working Capital and Capital Spending Remember that additional investments in NWC are assumed to be recouped when the project is closed out, just as the project will be sold (or scrapped) at the end of its life.
    3. Projected Total Cash Flow and Value Note the relationship between project cash flow, NPV, and firm value: all else equal, higher cash inflows will result in a higher NPV which, in turn, represents an increase in firm (and shareholder) value.
  4. More on Project Cash Flow (54.0K)
    1. A Closer Look at Net Working Capital: The change in net working capital is equal to the change in _____ less the change in _____. CONCEPT CHECK
    2. Depreciation is a noncash expense that is relevant to capital budgeting primarily because it impacts cash outflows by reducing taxes. For tax purposes, depreciation expense is computed under a system enacted as part of the Tax Reform Act of 1986.
      • Modified ACRS Depreciation (MACRS) (53.0K)
      • Book Value versus Market Value Asset book values and market values rarely coincide. What is the definition of book value? Of market value? CONCEPT CHECK
  5. Evaluating NPV Estimates (53.0K)
    1. The Basic Problem Unless the decision-maker has a crystal ball, s/he runs the risk of computing erroneous NPV estimates. Overestimating NPVs results in the acceptance of some "bad" projects that appear initially to be good; underestimating NPVs results in the rejection of "good" projects that appear to be "bad."
    2. Forecasting Risk is the possibility that errors in projected cash flows lead to incorrect decisions.
    3. Sources of Value Basic economics suggests that "good" projects are not all that common due to competition for them. Value is created when a project contributes to increased revenues and/or decreased costs.
  6. Scenario and Other What-If Analyses
    1. Getting Started The first step is to develop a base case (KEY TERM). This will be used in the "What-If" analyses described below.
    2. Scenario Analysis (53.0K) is the development of NPV estimates using "best-case" and "worst-case" assumptions about various input values (such as net income, cash flows, project costs, etc.).
    3. Sensitivity Analysis (52.0K) is the development of NPV estimates allowing only one variable to vary at a time. Sensitivity analysis allows us to determine which input variables have the greatest impact on NPV.
  7. Additional Considerations in Capital Budgeting
    1. Managerial Options and Capital Budgeting (09016) Managerial options are opportunities that managers can exploit if certain things happen in the future.
      • Contingency Planning is the attempt to take into account the managerial options implicit in a project. Such options include the option to expand (KEY TERM), the option to abandon (KEY TERM), and the option to wait (KEY TERM).
      • Strategic Options are opportunities to exploit future related business opportunities. The existence of strategic options make a project difficult to value using DCF methods.
    2. Capital Rationing (53.0K) occurs whenever the firm has positive-NPV investment opportunities but cannot obtain the funds necessary to finance them.
      • Soft Rationing occurs when units in a business are allocated a certain amount of financing for capital budgeting purposes.
      • Hard Rationing occurs when a business cannot raise financing for a project under any circumstances.





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