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CHAPTER 12 Cash Flow EstimationRelevant cash flows
Some points to remember in calculating cash flows
Focus on incremental cash flows—the difference in cash flows
because of this project
Forget sunk costs– costs that have accrued in the past
By Donglin Li
Some points to remember in calculating cash flows
Include opportunity costs– costs of highest potential benefits
forgone by taking this project
Consider incidental effects—(also called side effects,
externality)
Positive side effects – benefits to other projects
Negative side effects – costs to other projects
Sounds abstract, but you all have applied these rules.
By Donglin Li
Relevant (incremental) Cash Flows
The cash flows that should be included in a capital budgeting
analysis are those that will only occur if the project is
accepted
These cash flows are also called incremental cash flows
We analyze each project in isolation from the firm simply by
focusing on incremental cash flows
By Donglin Li
Asking the Right Question
You should always ask yourself “Will this cash flow occur ONLY if
we accept the project?”
If the answer is “yes”, it should be included in the analysis
because it is incremental
If the answer is “no”, it should not be included in the analysis
because it will occur anyway
If the answer is “part of it”, then we should include the part that
occurs because of the project
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Sunk costs
The sunk cost is past cost and irreversible. Since it cannot be
affected by the decision to accept or reject the project, it should
be ignored.
Is your education cost so far at SFSU sunk cost?
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By Donglin Li
You plan to produce ice cream using some facility that you bought
at $50,000 last year.
Should this $50,000 cost from the previous year be included in the
analysis?
No, this cost is a sunk cost and should not be considered.
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The highest benefit forgone when you take a project
The opportunity cost may be relevant to the investment decision
even when no cash changes hands.
Give me an example about the opportunity cost of studying at
SFSU?
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You plan to use the facility to produce ice creams. The facility
could be leased out for $25,000 per year, would this affect the
analysis?
Yes, by accepting the project, the firm foregoes a possible annual
cash flow of $25,000, which is an opportunity cost to be charged to
the project.
The relevant cash flow is the annual after-tax opportunity
cost.
A-T opportunity cost = $25,000 (1 – T)
= $25,000(0.6)
= $15,000
The “side effects” of taking a project.
Give me an example of incidental effect if you got a degree from
SFSU.
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If the ice cream production were to decrease the sales of the
firm’s other lines (for example, Yogurt), would this affect the
analysis?
Yes. The effect on other projects’ CFs is an “externality.”
Decreased CF per year on other lines would be a cost to this
project.
Externalities can be positive (in the case of complements) or
negative (substitutes).
Externality (also called incidental effect) is relevant.
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The NPV estimates are just that – estimates
A positive NPV is a good start – now we need to take a closer
look
Forecasting risk – how sensitive is our NPV to changes in the cash
flow estimates; the more sensitive, the greater the forecasting
risk.
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(Stand-alone risk, Corporate risk, Market risk)
Sensitivity analysis
Scenario analysis
Exercise Questions
A cost that has already been paid, or the liability to pay has
already been incurred, is a(n):
a. Salvage value expense.
c. Sunk cost.
d. Opportunity cost.
By Donglin Li
By Donglin Li
You bought some real estate 6 years ago for $25,000, and you are
thinking of using this land for the construction of a new warehouse
as part of a production expansion project.
You include the $25,000 purchase cost of the land as an initial
cost in the capital budgeting process. By doing so, you are making
the mistake of in the decision-making process.
a. including erosion costs
b. including opportunity costs
c. including sunk costs
e. including financing costs
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You bought some real estate 6 years ago for $25,000, and you are
thinking of using this land for the construction of a new warehouse
as part of a production expansion project.
You do NOT consider the $25,000 purchase cost of the land as an
initial cost in the capital budgeting process. You also ignore the
fact that the land now can be sold at $28,000. By doing so, you are
making the mistake of ______in the decision-making process.
a. excluding erosion costs
b. excluding opportunity costs
c. excluding sunk costs
d. including opportunity costs
e. including sunk costs
By Donglin Li
You bought some real estate 6 years ago for $25,000, and you are
thinking of using this land for the construction of a new warehouse
as part of a production expansion project.
You correctly do NOT consider the $25,000 purchase cost of the land
as an initial cost in the capital budgeting process. You also
correctly consider the fact that the land now can be sold at
$30,000. But you forget to consider the fact that the new warehouse
will attract more customer in the region and your other business
(retailing, for example) will be positively affected. By doing so,
you are making the mistake of ____in the decision-making
process.
a. excluding erosion costs
b. excluding opportunity costs
c. excluding sunk costs
d. excluding incidental effects
e. excluding financing costs
a. Accepting one automatically implies rejection of the
other.
b. If one is undertaken, the other must be undertaken as
well.
c. Both will be undertaken, assuming each has a positive NPV and
the firm’s capital budget can afford to include both
projects.
d. All of the above
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a. The difference between after-tax cash flows and before-tax
accounting profits.
b. The additional cash flows that will be generated if a project is
undertaken.
c. The cash flows of a project, minus financing costs.
d. The cash flows that are foregone if a firm does not undertake a
project.
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Which of the following should be included in an analysis of a new
project?
a. Any sales from existing products that would be lost if customers
were expected to purchase a new product instead.
b. All financing costs.
c. All sunk costs.
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Adams Audio is considering whether to make an investment in a new
type of technology.
Which of the following factors should the company consider when it
decides whether to undertake the investment?
a. The company has already spent $3 million researching the
technology.
b. The new technology will affect the cash flows produced by its
other operations.
c. If the investment is not made, then the company will be able to
sell one of its laboratories for $2 million.
d. Statements b and c should be considered.
e. All of the statements above should be considered.
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