Chpt 10

opportunity cost

the most desirable alternative given up as the result of a decision

Bottom up approach

start with the accountant's bottom line (net income) and add back any noncash deductions such as depreciation.

stand-alone principle

the assumption that evaluation of a project may be based on the project's incremental cash flows

Erosion

the cash flows of a new project that come at the expense of a firm's existing projects

incremental cash flows

the difference between a firm's future cash flows with a project and those without the project

Operating cash flow formula

= Earnings before interest and taxes + depreciation - taxes

Project cash flows formula

= Project operating cash flow- project change in net working capital- project capital spending

bottum-up approach net income

Because we are ignoring any financing expenses, such as interest, in our calculations of project OCF, we can write project net income as: EBIT- Taxes

Financing Costs

In analyzing a proposed investment, we will not include interest paid or any other financing costs such as dividends or principal repaid because we are interested in the cash flow generated by the asset of the project.

Net working capital

Normally a project will require that the firm invest in net working capital in addition to long term assets.

Tax Shield Approach to OCF

OCF = (sales-costs) * (1-Tc) + (Depreciation*Tc) where Tc = corporate tax rate

bottom up approach OCF

OCF= net income + depreciation.

Top Down approach OCF

OCF= sales-costs-taxes

Top down approach

We start at the top of income statement with sales and work our way down to net cash flow by subtracting costs, sales, and other expenses.

sunk cost

a cost that has already been committed and cannot be recovered

Accelerated cost recovery system

a depreciation method under U.S. tax law allowing for the accelerated write-off of property under various classifications

EBIT

earnings before interest and taxes

pro forma financial statements

financial statements projecting future years' operations

Equivalent annual cost

the present value of a project's costs calculated on an annual basis

Depreciation tax shield

the tax saving that results from the depreciation deduction, calculated as depreciation multiplied by the corporate tax rate