FIN 614: Financial Management Larry Schrenk, Instructor

1.Two General Principles 1.Use Increments 2.Use Real Cash Flows

Principle One: Use Increments. The Incremental Approach to Cash Flow Analysis Principle Two: Use Real Cash Flows. Real versus Accounting Cash Flows

The Incremental Approach to Cash Flow Analysis Incremental: How real cash flows change Alternate: Averages

New Project Costs 2 Divisions Now, 3 After CostBeforeAfterAverageIncrement Furniture$10,000$12,000 Software $9,000 Insurance $4,000 $6,000

Average Approach CostBeforeAfterAverageIncrement Furniture$10,000$12,000 $4,000 Software $9,000 $3,000 Insurance $4,000 $6,000 $2,000

Incremental Approach change in costs, i.e., the increment, associated with the new project: CostBeforeAfterAverageIncrement Furniture$10,000$12,000 $4,000 $2,000 Software $9,000 $3,000 $0 Insurance $4,000 $6,000 $2,000

Conclusion: Use the increment CostBeforeAfterAverageIncrement Furniture$10,000$12,000 $4,000 $2,000 Software $9,000 $3,000 $0 Insurance $4,000 $6,000 $2,000

Real: Actual transfers of value at this time; Market values Money, assets, etc. Accrual Accounting May not be market values Goodwill, depreciation May not be current ‘accrued’, ‘payable’ NOTE: Possible ambiguity… Real versus Accounting Real versus Nominal

Payment of $6,000 for insurance over the next three years. AccountingReal

Accrual Accounting Cash Flow ‘Matching’ Profit AccountingReal $2,000

Real Cash Flow AccountingReal $2,000$6,000 $2,000$0 $2,000$0

A Complication Non-real cash flow has an effect on a real cash flow. Incorporate the effect, but not non-real cash flow itself. Depreciation

FIN 614: Financial Management Larry Schrenk, Instructor