Fundamentals of Corporate Finance

Colin Firer et al

Key Concepts and Skills

How to determine the relevant cash flows for a proposed investment How to analyze a projects cash flows

Chapter 10 Making Capital Investment Decisions

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Project Cash Flows

Capital budgeting process

Project Cash Flows

Project

Establish which information should be considered

Decide whether or not to invest in a project

Changes cash flows of company

Today + future

Consider changes in cash flows and decide!!!

Do a discounted cash flow analysis

These cash flows are called incremental cash flows

Relevant 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 Cash flows
Not profits Depreciation irrelevant

Stand alone principle

The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on incremental cash flows

Cash flow dependent on acceptance of the project.

These cash flows are called incremental cash flows

If the project is not accepted, the cash flow will not take place

Focus only on the cash flows of the specific project

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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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Common Types of Cash Flows

Sunk costs Opportunity costs Side effects Changes in net working capital Financing costs Inflation
Cash flows that have already taken place in the past Cannot be changed or reversed by the decision costs of lost options Cash flows that could have been generated from the best alternative use of an asset

Positive side effects benefits to other projects Negative side effects costs to other projects

= loan Supplies NWC at the beginning and withdraw at the end.

Indeed a cash flow BUT cost of capital already includes the required return on debt

Long term investment inflation likely to occur Already included in discount rate

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Example
Grasshopper (Pty) Ltd is considering a new contract to service the garden of a local townhouse complex. Which of the following costs is relevant to this decision? The salary of the receptionist Salary of the supervisor already employed by the company Rent of the office space Wages of extra staff to be employed for this contract
Fin Man 2A 9