1. Cash Flow Estimation Basic Concepts

2. Overview Most difficult aspect of capital budgeting Long time frame ▫Leads to uncertainty Typical bias: overstate revenues and understate costs Nevertheless, it must be carried out

3. Relevant Cash Flows Only These are called “incremental” cash flows That is, the CF’s that occur due to the undertaking of the project Thus, “sunk costs” (expenditures already made) must NOT be included Ex: Mktg study is done about feasibility ($8,000) before doing the project Do not include $8,000 into the CF’s

4. Opportunity Costs They must be included, though can be difficult to calculate “What could have been earned otherwise” or “best alternative if not this project” EX: Use your own land to build the factory Must include the opportunity cost of the land (what could you have rent it for?)

5. Externalities “Impact of the project in consideration (the capital budgeting project) onto existing projects” If the project benefits other existing projects, include the benefit to the existing projects into the CF’s of this project (positive) If the project hurts other existing projects (cannibilize), include this cost into the CF’s

6. Depreciable Basis The amount of $$ that is used to calculate depreciation (what we multiply the depreciation rates by) Only long term assets plus shipping, modifications, installation Does not include NWC investments Depreciation: use the fastest possible (MACRS)

7. Net Working Capital Initial investment needed to support the capital investment Ex: inventories or cash Can be offset by “free” financing such as AP So the net effect is NWC Assume recovery of this investment at the end of the project

8. Net Salvage At the end of the project, we assume that the long term investment will be sold (salvage) This must be adjusted for tax effects (thus “net”) Salvage value +- tax impact= net salvage Tax impact: ▫If gain (salvage > book value), pay taxes on that gain (-) (reduces the salvage value) ▫If a loss (salvage < book value), tax savings on the loss (+) (increase the salvage value)