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Lecture Fundamentals of finance – Chapter 9: Making capital investment decisions

The topic discussed in this chapter is making capital investment decisions. In this chapter, you will learn: Understand how to determine the relevant cash flows for a proposed investment, understand how to analyse a project’s projected cash flows, understand how to evaluate an estimated NPV. | Chapter 9 Lecture - Making Capital Investment Decisions CHAPTER 9 LECTURE - MAKING CAPITAL INVESTMENT DECISIONS SECTIONS (9.1, 9.2, 9.6) Relevant Cash Flows • Include only cash flows that will only occur if the project is accepted • Incremental cash flows • The stand-alone principle allows us to analyze each project in isolation from the firm simply by focusing on Incremental Cash Flows Corporate cash flow with the project Minus (-) Corporate cash flow without the project LEARNING OBJECTIVES After studying this chapter, you should be able to: LO1 Determine the relevant cash flows for a proposed investment. LO2 Evaluate an estimated NPV. 9-1 9-2 Relevant Cash Flows • • • • • • Sunk Costs (N) “Sunk” Costs N Opportunity Costs . Y Side Effects/Erosion Y Net Working Capital Y Financing Costs . . N Tax Effects Y • • Such a cost cannot be changed by the decision today to accept or reject a project. • Put another way, the firm will have to pay this cost no matter what. • Based on our general definition of incremental cash flow, such a cost is clearly not relevant to the decision at hand. • 9-3 A sunk cost, by definition, is a cost we have already paid or have already incurred the liability to pay. So, we will always be careful to exclude sunk costs from our analysis. 9-4 1 Chapter 9 Lecture - Making Capital Investment Decisions Opportunity Costs (Y) Side Effects (Y) • Remember that the incremental cash flows for a project include all the changes in the firm's future cash flows. It would not be unusual for a project to have side, or spillover, effects, both good and bad. • An opportunity cost is slightly different; it requires us to give up a benefit. • A common situation arises where a firm already owns some of the assets a proposed project will be using. • For example, we might be thinking of converting an old rustic cotton mill we bought years ago for $100,000 into “upmarket” .