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Fundamentals
of Capital
Budgeting
Chapter Outline
7.1 Forecasting Earnings
7.2
Determining Free Cash Flow and NPV
7.3 Choosing Among Alternatives
7.4
Further Adjustments to Free Cash Fl
ow
7.5 Analyzing the Project
Copyright 2011 Pearson Prentice Hall. All rights reserved.
7-2
Learning Objectives
1. Given a set of facts, identify relevant cash flows
for a capital budgeting problem.
2. Explain why opportunity costs must be included in
cash flows, while sunk costs and interest expense
must not.
3. Calculate taxes that must be paid, including tax
loss carryforwards and carrybacks.
4. Calculate free cash flows for a given project.
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7-4
Capital Budgeting
Process used to analyze alternate investments
and decide which ones to accept
Incremental Earnings
The amount by which the firms earnings are
expected to change as a result of the investment
decision
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Interest Expense
In capital budgeting decisions, interest
expense is typically not included. The
rationale is that the project should be
judged on its own, not on how it will be
financed.
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Taxes
Marginal Corporate Tax Rate
The tax rate on the marginal or incremental
dollar of pre-tax income. Note: A negative tax
is equal to a tax credit.
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Taxes (cont'd)
Unlevered Net Income Calculation
Unlevered Net Income EBIT (1 c )
(Revenues Costs Depreciation) (1 c )
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Real-World Complexities
Typically,
sales will change from year to year.
the average selling price will vary over time.
the average cost per unit will change over time.
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FCFt
FCFt
t
(1 r )
1
(1 r )t
14 2 43
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Accelerated Depreciation
Modified Accelerated Cost Recovery System
(MACRS) depreciation
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Further Adjustments
to Free Cash Flow (cont'd)
Liquidation or Salvage Value
Capital Gain Sale Price Book Value
Book Value Purchase Price Accumulated Depreciation
After-Tax Cash Flow from Asset Sale Sale Price (c Capital Gain)
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Further Adjustments
to Free Cash Flow (cont'd)
Terminal or Continuation Value
This amount represents the market value of the
free cash flow from the project at all future
dates.
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Further Adjustments
to Free Cash Flow (cont'd)
Tax Carryforwards
Tax loss carryforwards and carrybacks allow
corporations to take losses during its current
year and offset them against gains in nearby
years.
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Sensitivity Analysis
Sensitivity Analysis shows how the NPV
varies with a change in one of the
assumptions, holding the other
assumptions constant.
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Scenario Analysis
Scenario Analysis considers the effect
on the NPV of simultaneously changing
multiple assumptions.
Table 7.10 Scenario Analysis of Alternative Pricing
Strategies
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Chapter Quiz
1. Should you include sunk costs in the cash flow
forecasts of a project? Why or why not?
2. Should you include opportunity costs in the cash
flow forecasts of a project? Why or why not?
3. What adjustments must be made to a projects
unlevered net income to determine its free cash
flows?
4. How do you choose between mutually exclusive
capital budgeting decisions?
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Chapter 7
Appendix
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