Chapter 6: Making capital investment decisions

Transcript:Chapter 6: Making capital investment decisions:
Chapter 6: Making capital investment decisions Corporate Finance Outline I. Relevant/incremental cash flows II. An example III. The equivalent annual cost method TVM We need to evaluate a new project using the TVM technique. That is, we should discount future expected cash flows (specifically, FCFs) back to present time and compare PV to initial costs: whether NPV > 0? Discount after-tax cash flows, not earnings. Relevant cash flows But before we do this, a few notions about cash flows need to be addressed. The cash flows in the capital-budgeting time line need to be relevant cash flows; that is they need to be incremental in nature. Incremental cash flows: those cash flows that will only occur if the project is accepted. Ask 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. Sunk costs A sunk cost is a cost that has already occurred regardless of whether the project is accepted. Example: consulting fee for evaluating a project. Sunk costs should not be taken into consideration when evaluating a project. Opportunity costs Opportunity costs (OCs) are the costs of giving up the second best use of resources. Example: a vacant land. Opportunity costs should be taken into consideration when evaluating the project. Side effects Accepting a new project may have side effects. Erosion occurs when a new project reduces the sales and cash flows of existing projects. Synergy occurs when a new project increases the sales and cash flows of existing projects. Cash flows due to erosion and synergy are incremental cash flows. A sample question You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up (becoming troublesome) and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost. a. opportunity b. fixed c. incremental d. sunk e. relevant A sample question The most valuable alternative that is given up if a particular investment is undertaken is called: a. Sunk cost. b. Opportunity cost. c. Dead-weight cost. d. Erosion cost. e. None of the above. An