Chapter 8 Concepts

Erosion

Acceptance of one project causes the cash flows of another project to decrease. New project reduces cash flows of existing projects.

Replacement Questions

1. Calculate the NPV of costs at time 0 2. Use an Annuity to get the annual cost 3. Calculate the NPV of the cost at time 0 of alternative (include/add the opportunity cost!) 4. Use an annuity to get the annual cost 5. Compare the annual cost before replacement, lower annual cost wins.

Synergy

New project increases cash flows of existing project.

Tax Shield Approach

OCF = (Sales - Costs) X (1-t) + (Depreciation x t) (Sales - Costs) X (1-t) = without depreciation (Depreciation x t) = depreciation tax shield

Opportunity Costs

The cost of potential gains from an alternative project when one project is chosen. (Potential revenues lost from alternative)

Nominal Cash Flow

Actual dollars to be received

Real Cash Flow

Cash flows' purchasing power

Sunk Costs

Costs that have already been incurred. Ignore this when calculating value of a new project.

Depreciation Tax Shield

Depreciation deduction multiplied by the tax rate

Methods of Calculating Operating Cash Flow

OCF = EBIT + Depreciation - Taxes Bottom Up Approach: OCF = Net Income + Depreciation Top Down Approach: OCF = Sales - Costs - Taxes Tax Shield Approach: OCF = (Sales - Costs) X (1-t) + (Depreciation x t)

Incremental Cash Flow

Only includes additional cash flows received from the project (ignores cash flows that would normally be received even without the project)

Equivalent Annual Cost Method

Projects with unequal lives 1. Calculate the NPV 2. Create an annuity to determine the average annual cost over the life of the project (calculate the PMT) 3. Compare the PMTs. Project with lower cost per year gets accepted.

Fisher equation

Real Discount = Nominal Discount / Inflation Rate

Allocated Costs

Spreads the cost of an expenditure over the projects that benefit from it. This cost should only be viewed as a cash outflow of a project if it is an incremental cost of the project.

Net working capital

The difference between current assets and current liabilities.