Chapter 10 – More Capital Budgeting Key Sections: Guidelines for cash flows Classifications of cash flows –Explain why interest and depreciation not included Are different discount rates needed?

Guidelines What will happen if the project is not carried out? Use after-tax cash flows, not accounting profits Only incremental cash flows count –Look at whole firm with and without project –Consider: sales captured from competitors, synergies and cannibalization

More Guidelines Work in working capital requirements Incremental expenses – training, rearrangement Cash flows not affected by sunk costs Opportunity costs – give up something Are overhead costs incremental? Ignore interest expense

Measuring Costs and Benefits Initial outlays – fully installed cost, less sale of old property and tax effect Differential cash flows – increased revenues/savings; adjusted for incremental tax effects; interest is excluded Terminal cash flows – cleanup, salvage, working capital recapture

5 Initial Outlay Purchase price$30 Shipping 2 Installation 3 Employee training 2 Tax on sale of old machine 1 Increased inventory 5 Total outflows 43 Sale of old machine- 15 Initial outlay 28

6 Differential Cash Flows Reduced salaries$10 Reduced fringe 1 Reduced defects 5 Increased maintenance -4 Increased depreciation NA Net savings 12 Less: tax effect -3 Annual cash flow 9

7 Terminal Cash Flow Salvage Value $12 Tax impact-1 Cleanup/rearrangement-2 Reduced inventory 3 Terminal cash inflows +12

Risk in Capital Budgeting Risk – potential variability in cash flows –Uncertain outcome but can apply judgmental probabilities Risk adjusted discount rate – adjusted upward to compensate for risk; lowers NPV IRR – cutoff rate increased

Ford Motor Co. Approach “Normally, all investment proposals are expected to generate an after-tax, time- adjusted rate of return [= IRR] of at least __%. Proposals with higher than normal risk are expected to generate commensurately higher returns. For a number of overseas areas, the minimum return is higher than ___%.”