Capital Investments and FCF
Capital Investments and FCF
Investment Decisions
Key Concepts and Skills
Understand how to determine the relevant
cash flows for various types of capital
investments
Be able to compute depreciation expense
for tax purposes
Incorporate inflation into capital budgeting
Understand the various methods for
computing operating cash flow
Incremental Cash Flows
Cash flows matternot accounting earnings.
Sunk costs do not matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like cannibalism and erosion
matter.
Taxes matter: we want incremental after-tax
cash flows.
Inflation matters.
Cash FlowsNot Accounting
Income
Consider depreciation expense.
You never write a check made out to
depreciation.
Much of the work in evaluating a
project lies in taking accounting
numbers and generating cash flows.
Incremental Cash Flows
Sunk costs are not relevant
Just because we have come this far does
not mean that we should continue to throw
good money after bad.
Opportunity costs do matter. Just because
a project has a positive NPV, that does not
mean that it should also have automatic
acceptance. Specifically, if another project
with a higher NPV would have to be
passed up, then we should not proceed.
Incremental Cash Flows
Side effects matter.
Erosion and cannibalism are both bad
things. If our new product causes
existing customers to demand less of
current products, we need to recognize
that.
If, however, synergies result that create
increased demand of existing products,
we also need to recognize that.
Estimating Cash Flows
T 10 T 5
R 10 R 10
Replacement Chain
Repeat projects until they begin and end at
the same time.
Compute NPV for the repeated projects.
The Equivalent Annual Cost Method
Replacement Chain Approach
The Cadillac cleaner time line of cash
flows:
-$4,000 100 -100 -100 -100 -100 -100 -100 -100 -100 -100
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
Replacement Chain Approach
Cadillac Air Cleaner Cheapskate Air Cleaner
CF0 4,000 T 10
CF1 100 R 10
T 10 PV 4,614.46
R 10 PMT 750.98
NPV 4,614.46 FV
Cheapskate EAC with a Calculator
CF0 1,000 T 5
CF1 500 R 10
T 5 PV -2,895.39
R 10 PMT 763.80
NPV 2,895.39 FV
Cost-Cutting Proposals