Capital Budgeting MOD3

If the market value is smaller than the book value, can you still use the same formula to calculate after tax salvage value? Yes or No

Yes

If the market value is smaller than the book value, the business can get tax credits.

When selling a piece of secondhand equipment, the total tax that a company needs to pay is computed using the tax rate times the difference between the market value and the book value.

A positive NPV is an indicator to…

Take on a project

In capital budgeting it is important to

Ignore sunk cost and include opportunity cost

To find the book value of an equipment you need…

You need to know the original cost of the machine and the accumulated depreciation during years of ownership.

The term for a new product that brings an increase in sales and cash flow flows to existing projects is called…

Synergy

The Apple Watch is a product that generates

Synergy

With the iPhone

Erosion

Erosion happens when a new product reduces the sales and cash flows of an existing one

Shoppers who buy the most recent model of cell phone from the same cell phone company that still sells the previous model may impact of the company via:

Erosion

A firm should take erosion and synergy into account in a capital budgeting process

When calculating incremental cash flow a firm deducts cash flows from erosion and adds cash flows from synergy

Incremental cash flow

Cash flow that happens because of the adoption of the project

If positive net present value, firm should accept project

Capital budgeting: depreciation

-Depreciation is deducted in income statement

-However, depreciation needs to be added back to derive cash flow

The total cash flows generated from a project comes from 3 sources

• Operating Cash Flow

• Net Capital Spending

• Changes in Net Working Capital

Operating Cash Flow (OCF)

OCF = EBIT + Dep. - Taxes

• depreciation is deducted for a bit, but needs to be added back for OCF

• Taxes must be taken out

Example: extra revenue from the project minus extra operating costs, adjusted for taxes and depreciation

Net capital spending

• Cash flows at beginning: initial expenditure

• Plant and equipment sold at the end of project

Definition: cash out flows for purchasing fixed assets minus any salvage value received at the end.

Example: buy a machine for $100,000 now sell it for 20,000 at the end. net spending equals $100,000 outflow and $20,000 inflow later.

Changes in networking capital

• initial investment in networking capital

• When the project ends networking will be reduced to zero

Definition: additional investment in current assets(inventory receivable) minus current liabilities needed for the project

Timing: usually an outflow at project start(increase in NWC) and an in flow at the end (recovery of NWC).

Example: if you need $10,000 more in inventory, that’s an initial cash outflow. When the project ends you sell off inventory and recover $10,000.

Opportunity cost

Is the dollar amount of opportunity a firm gives up.

The best alternative is the opportunity cost

Sunk costs

• A sun cost is a cost that has already occurred

• Cannot be recovered

• Cannot be changed by decision of project

• Sunk costs are not incremental cash flows