Project Cash Flows | Corporate Finance | CPA Exam BAR | CMA Exam | Chp 10 p 1

Summary

In this lecture, the focus is on making capital investment decisions through cash flow analysis. The speaker defines essential terms like incremental cash flow, sunk costs, opportunity costs, and the Standalone Principle. The lecture emphasizes the importance of understanding relevant costs and cash flows, ignoring sunk costs, and recognizing the impact of opportunity costs. The speaker also explains the significance of net working capital, financing costs, and after-tax cash flow in project evaluation. Ultimately, the goal is to evaluate the potential value a project can add to a firm, considering both its financial and operational impacts.

Takeaways

• 😀 The main concept of capital investment decisions is that a company will only undertake a project if it adds value by increasing cash flow.
• 😀 Incremental cash flow refers to the change in a company's overall future cash flow directly caused by the decision to take on a project.
• 😀 Sunk costs, which are costs that have already been incurred and cannot be changed by the decision to accept or reject a project, are considered irrelevant in cash flow analysis.
• 😀 Opportunity costs are relevant in project evaluation. They represent the value of the best alternative that is given up when choosing a specific project.
• 😀 The Standalone Principle suggests analyzing a project independently, as if it were a separate entity, by focusing only on the incremental cash flows directly affected by the project.
• 😀 Financing costs, such as interest and dividends, are ignored in project evaluation because the focus is on the operational cash flow generated by the project, not the way it is financed.
• 😀 Erosion refers to negative side effects, such as when a new product eats into the sales of an existing product, while spillover effects are positive, like increased sales from related product offerings.
• 😀 Network capital (NWC) is the difference between a project's current assets and current liabilities, and it impacts cash flow both during the project and upon its completion.
• 😀 After-tax cash flow is critical in project evaluation, as taxes represent a cash outflow that must be considered. It's different from accounting profit or net income.
• 😀 When evaluating a project, only the relevant cash flows that arise directly from the project should be included, excluding any costs that are fixed or irrelevant, such as sunk costs.

Q & A

What is the key concept behind making capital investment decisions?

The key concept is that a company will undertake a project only if it adds value to the company. A project adds value if it increases cash flow after taxes.

What is the definition of incremental cash flow?

Incremental cash flow refers to any and all changes in a firm's future cash flow that are directly caused by the decision to undertake a project. It includes only the cash flows that change as a result of the project, and not those that would occur regardless.

What is the Standalone principle in capital investment decisions?

The Standalone principle states that once a project's incremental cash flow has been identified, it should be treated as its own separate entity, similar to a mini firm, and its cash flows should be analyzed independently from the rest of the firm's cash flows.

Why are sunk costs ignored in cash flow analysis?

Sunk costs are ignored because they are costs that have already been incurred or will be incurred regardless of whether the project is undertaken. These costs do not change based on the project decision and are considered irrelevant.

What is an example of a sunk cost?

An example of a sunk cost is the fee paid to a consultant for evaluating a project, which must be paid regardless of whether the project is accepted or rejected.

What is an opportunity cost, and why is it relevant?

An opportunity cost refers to the value of the benefit that is foregone by choosing one alternative over another. In the context of capital investment, opportunity costs are relevant because they represent the benefits that the company could lose by using resources for the new project instead of alternative uses.

How is opportunity cost calculated in capital investment decisions?

Opportunity cost is calculated based on what the firm would give up by using an asset for the new project, such as the potential income from selling the asset or using it for a different purpose.

What is erosion in the context of capital investment decisions?

Erosion refers to the negative side effect of a new project that causes a decline in sales of an existing product. For example, the introduction of the iPhone eroded the sales of the iPod because both devices offered similar functionality.

What is a spillover effect, and how does it relate to capital investments?

A spillover effect is a positive side effect of a project that leads to increased sales or benefits in other areas. For instance, lowering the price of a printer could lead to an increase in sales of related consumable products like ink cartridges and paper.

Why is networking capital important in cash flow analysis?

Networking capital is important because every project requires an investment in current assets like inventory and receivables, and corresponding liabilities like accounts payable. These changes in working capital affect the cash flow at the beginning and end of the project.