Topic 4 - Making Capital Investment Decision (1)
4 Making Capital Investment Decisions
6-1 Key Concepts and Skills
Importance of determining relevant cash flows for capital investments.
Computation of depreciation expense for tax purposes.
Incorporation of inflation in capital budgeting decisions.
Understanding various methods for calculating operating cash flow.
Evaluation of special cases in discounted cash flow analysis.
6-2 Incremental Cash Flows
Cash flows are critical, not just accounting earnings.
Sunk Costs: Past costs that should not affect current decisions.
Opportunity Costs: Foregone benefits from alternatives should be considered.
Side Effects: Includes both cannibalism (reduction in existing products' sales) and erosion (negative impacts on other revenue streams).
Taxes: Focus on after-tax incremental cash flows.
Inflation: Must be factored into cash flow estimates.
6-3 Cash Flows vs. Accounting Income
Corporate finance relies on cash flows, whereas financial accounting focuses on profit.
Cash flow reflects real timing and costs of transactions.
Accounting profits do not indicate actual cash availability.
6-4 Characteristics of Incremental Cash Flows
Sunk Costs: Not relevant to future decisions.
Opportunity Costs: Must evaluate alternatives; a project with positive NPV may still be less favorable if a better option exists.
Depreciation Expense: Non-cash item but important for tax impact.
6-5 Side Effects of Cash Flows
Erosion is detrimental; necessitates acknowledgment of decreased demand for existing products.
Favorable synergies from a new product idea should also be assessed.
6-6 Estimating Cash Flows
Operating Cash Flow Formula: OCF = EBIT – Taxes + Depreciation.
Consideration for net capital spending and Salvage Value post-tax.
Account for changes in net working capital throughout project life.
6-7 Relevance of Interest Payments and Financing Costs
Interest and financing costs are irrelevant; required return accounts for funding costs.
Depreciation: Relevant for tax purposes even though it's a non-cash expense.
Taxes must be considered on an after-tax basis.
6-8 Components of Capital Budgeting Steps
Initial Investment: Cash outflow at time zero for the project.
Operating Cash Inflows: Incremental after-tax cash inflows over the project’s life.
Terminal Cash Flow: After-tax non-operating cash flow at the project’s end, related to liquidation.
6-9 Calculating Initial Outlay
Initial Outlay includes immediate cash outflow to acquire the asset and mobilize it (purchase costs, setup, installation, etc.).
6-10 Annual Cash Flow Calculation
Annual cash flows are the net incremental cash flows resulting from the project.
IMPORTANT: Reflects all revenues, costs, taxes, and depreciation adjustments.
6-11 Terminal Cash Flow at Project's End
Cash flow from project liquidation at its economic life's end is considered.
**Tax Implications:
If Sale = Book Value: No tax effect.
If Sale > Book Value: Tax due on capital gain.
If Sale < Book Value: Tax refund as capital loss.**
6-12 After-tax Salvage Value
Calculated by considering tax effects due to differences between salvage and book value.
6-13 Capital Budgeting Steps: Evaluate Cash Flows
Breakdown of initial outlay, annual cash flows, and terminal cash flows.
6-14 Terminal Cash Flow, Example Breakdown
Example calculations showcasing the terminal cash flow including salvage value, tax impacts, and annual flows are provided for nuanced understanding.
6-15 Project NPV Evaluation
Demonstration of NPV calculations to establish project acceptability based on cash flows (initial, annual, terminal) against discount rate.
6-16 Problem Solving in NPV/IRR
Example projects with cost evaluations, cash flow analysis, and detailed calculations leading to NPV and IRR results are given.
6-17 NPV and IRR Calculation Summary
Concludes with a summary of NPV and IRR calculations showcasing project viability based on financial analysis.