FINC-220 Lecture Notes - Lecture 9: Capital Budgeting, Operating Cash Flow, Cash Flow

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8 May 2018

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Chapter 10- introduction

• Finding cash flows- were given to you in chapter 9

• Incremental cash flows

o The cash flows that should be included in a capital budgeting analysis are those

that will only occur (or not occur) if the project is accepted

o You should always ask yourself “will this cash flow occur only if we accept the

project?”

Common types of cash flows

• Sunk costs- costs that have accrued in the past- irrelevant

• Opportunity costs- costs of lost options – relevant

• Side effects- relevant

o Negative side effects- costs to other projects

o Positive side effects- benefits to other projects

• Changes in net working capital- relevant

• Financing costs- not related to capital budgeting

• Taxes- relevant

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Related Questions

Which of the following should be included in the capital budgeting decision

Select one:

A. Sunk costs

B. Opportunity costs

C. Relevant externalities

D. #2 and #3 should be included

E. All of the above should be included

Which of the following is NOT correct

Select one:

A. If an investment project would make use of land which the firm already owns, the opportunity cost of the land is a relevant cash flow and should be included with other project cash flows

B. Analysis of capital projects focuses on cash flows rather than accounting income

C. Changes in working capital do not need to be considered in capital project analysis

D. All of the above are correct

Stock dividends

Select one:

B. must be accompanied by cash dividends

C. are viewed unfavorably by investors and thus should not be used

D. have the same effect on financial statements as cash dividends

A project has initial costs of $5,000 and subsequent cash inflows of $1800, 1275, 1875, and 1525. The company's cost of capital is 10%. Calculate the Payback Period for the project

Gammy is considering building a facility to manufacture cupcakes to distribute nationally. Your assignment involves both the calculation of cash flows associated with the new investment under consideration and the evaluation of several mutually exclusive projects. Grammy wants you to meet with everyone involved and write a meeting report for the board of directors that includes your recommendation. In addition to the recommendation, you have been asked to respond to a number of questions aimed at understanding the capital-budgeting process. Grammy wants to be sure that she and the board of directors understand cash flow and capital budgeting.

We are considering constructing a building to manufacture cupcakes. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the project:

Cost of new plant and equipment	$7,900,000
Shipping and installation costs	$ 100,000
Unit Sales	Year Units Sold 1 70,000 2 120,000 3 140,000 4 80,000 5 60,000
Sales price per unit	$300/unit in years 1 through 4, $260/unit in year 5
Variable cost per unit	$180/unit
Annual fixed costs	$200,000 per year in years 1 â 5
Working-capital requirements	There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.
The depreciation method	Use the simplified straight-line method over 5 years. Assume the plant and equipment will have no salvage value after 5 years.

5. Answer the following questions:

a. Should you focus on cash flows or accounting profits in making the capital-budgeting decision? Should you be interested in incremental cash flows, incremental profits, total free cash flow, or total profits?

b. How does depreciation affect free cash flow?

c. How do sunk costs affect the determination of cash flows?

d. What is the projectâs initial outlay?

e. What are the differential cash flows over the projectâs life?

f. What is the terminal cash flow?

g. Draw a cash-flow diagram for this project.

h. What is its net present value?

i. What is its internal rate of return?

j. Should the project be accepted? Why or why not?

k. How does Genesis 47: 18 â 19 relate to this project and cash flow management?

35.Fairfax Pizza is evaluating a project that would require an initial investment in equipment of 400,000 dollars and that is expected to last for 9 years. MACRS depreciation would be used where the depreciation rates in years 1, 2, 3, and 4 are 44 percent, 34 percent, 16 percent, and 6 percent, respectively. For each year of the project, Fairfax Pizza expects relevant, incremental annual revenue associated with the project to be 600,000 dollars and relevant, incremental annual costs associated with the project to be 520,000 dollars. The tax rate is 50 percent. What is (X plus Y) if X is the relevant operating cash flow (OCF) associated with the project expected in year 1 of the project and Y is the relevant OCF associated with the project expected in year 4 of the project?

40.For project A, the cash flow effect from the change in net working capital is expected to be -500 dollars at time 2, the level of net working capital is expected to be 1,200 dollars at time 0, and the level of net working capital is expected to be 1,800 dollars at time 2. What is the cash flow effect from the change in net working capital expected to be at time 1?

Only answers should be fine. Thank you! :)

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FINC-220 Lecture Notes - Lecture 9: Capital Budgeting, Operating Cash Flow, Cash Flow

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