week 5 - Capital Budgeting II: Cash Flow Analysis and Replacement Decision

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7 Terms

1
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Free cash flows

(revenue-costs-depreciation)*(1-tax)+depreciation - CE - NWC

2
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initial outlay, ongoing cash flows, terminal cash flows

Initial outlay 

  • Purchase equipment

  • Initial development costs

  • Increase in net working capital (increase inventories, raw materials)

Ongoing cash flows 

  • Incremental revenues 

  • Incremental costs

  • Taxes

  • Change in net working capital (change in inventories, raw materials, accounts receivable and payable)

Terminal cash flows 

  • Sale of equipment 

  • Shut down costs

  • Decrease in neet working capital (decrease inventories, raw materials)

3
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FCF elements

Working capital 

  • Increase in WC during a period means more cash is employed ie cash outflow 

  • Decrease in WC during a period means less cash is employed ie cash inflow 

Capital expenditure - disposal of assets

  • When a depreciated asset is disposed → proceeds received is salvage value

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When an asset is liquidated, any capital gain is taxed as income

  • Capital gain = sale price = book value 

  • Book value = purchase price - accumulated depreciation

  • After tax cash flow from asset sale = sale price - (tax rate * capital gain)

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when to find book value

find book value

  • selling an assset

  • need to calcuclate gain or loss on the salle

  • aasked to find csah flow from selling aan aasset

no book value

  • the asaset isnt being sold or disposed of

  • unrellated to sale

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rules relating to FCF

  1. Only relevant cash flows (accounting income does not need to be recognised)

  2. Estimate cash flow on incremental basis

    1. They are cash flows arising only due to the project itself 

  3. Ignore sunk costs

    1. Costs already incurred

  4. Beware of allocated overheads

    1. Fixed costs, salaries, rent

    2. Only assign a change in these costs

  5. Include opportunity costs

  6. Exclude financing costs

  7. NWC = CA - CCL

  8. Treat inflation consistently

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nominal with nominal

  1. Nominal cash flow divided by inflation rate^years

    1. Vice versa

    2. Real rate times inflation rate^years

  2. Input into NPV