Chapter 12: Estimating Cash Flows on Capital Budgeting Projects

MACRS Depreciation

Accelerated depreciation Firms receive more depreciation earlier in asset's life Double-declining-balance method Results in double the depreciation rate used in straight-line

Gross Fixed Asset Changes

Almost always change at beginning and end of project At beginning, equals asset's depreciable basis At end, must consider tax consequences of sale

Demonstrate the EAC approach to choosing among alternative cash streams for recurring projects.

Alternative Assets with Differing Lives (EAC) - Situations where two different assets can be used for same purpose Requires restructuring each of the incremental cash flows associated with the assets for comparison

Section 179 Deductions

Assets can be expensed immediately Up to $500,000* of property placed in service each year Targeted at helping small businesses

ATCF -

Book value + (Market value - Book value) * (1 - T c)

Calculate a project's expected cash flows using the free cash flow approach.

Calculate Depreciation Operating Cash Flow Changes in Gross Fixed Assets Net Working Capital

Depreciation is

Depreciation basis - Ending book value / Life of asset

When calculating operating cash flow for a project, one would calculate it as being mathematically equal to which of the following?

EBIT - Taxes + Depreciation

Adjust initial project investments to account for flotation costs.

Flotation Costs - Can adjust project's initial cash flow to reflect flotation costs as well as investment in assets

Accelerated Depreciation and Half-Year Convention

IRS requires depreciation calculation using half-year convention Property assumed to be placed in service at midpoint of the period

Special Cases Are Not That Special

Incremental Free Cash Flow (FCF) can be used to calculate total project costs for many project types

Operating Cash Flow

OCF = EBIT - Taxes + Depreciation

Explain how accelerated depreciation affects project cash flows.

Opportunity Costs - Allocation of firm's resources represent lost opportunities Charge the project for assets used, wages and benefits

Identify which cash flows we can incrementally apply to a project and which ones we cannot.

Outlines relevant data to consider Identifies incremental cash flows directly attributable to new project adoption

Explain why we use pro forma statements to analyze project cash flows.

Process of estimating expected cash flows of project Uses relevant parts of the balance sheet and income statements

Calculate cash flows associated with cost-cutting proposals.

Substitutionary and Complementary Effects - Reductions or increases necessary to produce new products that are included in project cash flows Sales Costs Necessary assets

Calculate free cash flows for replacement equipment.

Sunk Costs - An expense or obligation the firm is compelled to pay regardless of whether a project is undertaken Never counted in project cash flows

Net Working Capital Changes

Use if project has steady sales or changes in NWC do not affect it Add NWC at project beginning and reduce at end Typical product unit sales follow bell-shaped curve Changes in levels of NWC throughout the project's life are what need to be financed, not the levels themselves

Effects that arise from a new product or service that increase sales of the firm's existing products or services are referred to as

complementary effects.

Flotation Cost Calculation

f a = E/E+P+D times f e + P/E+P+D times f p + D/E+P+D times f d Adjusted CF = CF / 1 -f a

Concerning incremental project cash flow, this is a cost one would never count as an expense of the project.

financing costs

Which of the following is NOT included when calculating the depreciable basis for real property?

financing fees

This is used as a measure of the total amount of available cash flow from a project.

free cash flow

A capital budgeting technique that generates decision rules and associated metrics for choosing projects based upon the implicit expected geometric average of a project's rate of return.

internal rate of return

A capital budgeting technique that generates a decision rule and associated metric for choosing projects based on the total discounted value of their cash flows.

net present value

Of the capital budgeting techniques discussed, which works equally well with normal and non-normal cash flows and with independent and mutually exclusive projects?

net present value

This technique for evaluating capital projects tells how long it will take a firm to earn back the money invested in a project.

payback

This is the process of estimating expected future cash flows of a project using only the relevant parts of the balance sheet and income statements.

pro forma analysis

This is the concept that a unit's sales will follow an approximate bell-shaped curve versus a steady sales life.

product life cycle

Effects that arise from a new product or service that decrease sales of the firm's existing products or services are referred to as

substitutionary effects.

If a firm has already paid an expense or is obligated to pay one in the future, regardless of whether a particular project is undertaken, that expense is a

sunk cost

As new capital budgeting projects arise, we must estimate

when such projects will require cash flows.