Estimating Project Cash Flows Capital Budgeting Estimating Project Cash Flows

The Balance Sheet (Figure 2.1) Total Value of Liabilities and Shareholders’ Equity Total Value of Assets Net Working Capital Current Liabilities Current Assets Long-Term Debt Fixed Assets 1. Tangible fixed assets 2. Intangible fixed assets Cost of Capital Shareholders’ Equity Income Statement

Incremental Cash Flows -- Items to think about Cannibalization of other products If a new product reduces the sales of other products, this reduction (Revenues - variable costs) is a cash outflow. Sales Creation Consider not only the new product, but also the possible increases in sales among other products. Opportunity Costs Include the market value of assets already owned. These assets have value as investments or when sold. Do not simply include them at book value or omit them. Sunk Costs Do not include costs that have already been incurred. Only value future cash flows, never past.

Incremental Cash Flows -- Items to think about (Cont.) Transfer Prices Prices charged between divisions must be market value. Often times accounting transfer prices are different than market prices for tax purposes. Allocated Overhead Accounting measures arbitrarily assign overhead costs via sales or space requirements. We should only include additional expenses that are incurred due to the implementation of this project. Inflation Make sure to include the affects of inflation on the cash flows. Our discount rate incorporates inflation and not including inflation in the cash flows will mean that we have undervalued the project. Financing Costs Do not include these in the cash flows. These are incorporated in the discount rate used.

T10.7 Modified ACRS Property Classes (Table 10.6) Class Examples 3-year Equipment used in research 5-year Autos, computers 7-year Most industrial equipment What Costs are Depreciable? Purchase Price Modification Costs Delivery Costs Installation Costs CQ2 Given the choice, would a firm prefer to use MACRS depreciation or straight line depreciation? Why?

Property Class Year 3-Year 5-Year 7-Year 1 33.33% 20.00% 14.29% T10.8 Modified ACRS Depreciation Allowances (Table 10.7) http://www.irs.gov/pub/irs-pdf/p946.pdf (page 71) Property Class Year 3-Year 5-Year 7-Year 1 33.33% 20.00% 14.29% 2 44.45 32.00 24.49 3 14.81 19.20 17.49 4 7.41 11.52 12.49 5 11.52 8.93 6 5.76 8.92 7 8.93 8 4.46