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FREE online courses on Capital Budgeting Analysis - Calculating the Discounted Cash Flows - Discounted Cash Flows

 

In capital budgeting analysis we want to determine the after tax cash flows associated with capital projects. We are concerned with all relevant changes or differences to cash flows once we invest in the project.

 

Understanding “Relevancy”

 

One question that we must ask in capital budgeting is what is relevant. Here are some examples of what is relevant to project cash flows:

 

Depreciation

 

Capital assets are subject to depreciation and we need to account for depreciation twice in our calculations of cash flows. We deduct depreciation once to calculate the taxes we pay on project revenues and we add back depreciation to arrive at cash flows because depreciation is a non-cash item.

 

Working Capital

 

Major investments may require increases to working capital. For example, new production facilities often require more inventories and higher salaries payable. Therefore, we need to consider the net change in working capital associated with our project. Changes in net working capital will sometimes reverse themselves at the end of the project.

 

Overhead

 

Many capital projects can result in increases to allocated overheads, such as computer support services. However, the subjective nature of overhead allocations may not make any difference at all. Therefore, you need to assess the impact of your capital project on overhead and determine if these costs are relevant.

 

Financing Costs

 

If we plan on financing a capital project, this will involve additional cash flows to investors. The best way to account for financing costs is to include them within our discount rate. This eliminates the possibility of double-counting the financing costs by deducting them in our cash flows and discounting at our cost of capital which also includes our financing costs.

 

We also need to ignore costs that are sunk; i.e. costs that will not change if we invest in the project. For example, a new product line may require some preliminary marketing research. This research is done regardless of the project and thus, it is sunk. The concept of sunk costs and relevant costs applies to all types of financing decisions. 

 

 

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