Capital budgeting : financial appraisal of investment by Don Dayanada; et al

By Don Dayanada; et al

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Extra resources for Capital budgeting : financial appraisal of investment projects

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This chapter will provide guidelines for identifying a project’s incremental cash flows, with illustrative examples. The discussion includes the stand-alone project principle, indirect or synergistic effects, the opportunity cost principle, the sunk cost concept, overhead cost allocation, the treatment of working capital, taxation, depreciation, investment allowances, financing (debt and interest) flows and inflation and timing of cash flows. Cash flow estimation of asset expansion projects and asset replacement projects will be illustrated by calculated examples.

The next two chapters discuss selected quantitative and qualitative forecasting methods. Chapter 6 shows how to evaluate projects by applying the NPV and other project valuation criteria to cash flows to facilitate decision-making on proposed projects. 1 A simplified hypothetical accounting income statement for XYZ Company is given below. Income Statement for XYZ Company, year ending 31 December 2002 $ millions Sales Cost of goods sold Other expenses Selling, general and administrative expenses Depreciation Earnings before interest and taxes (EBIT) Interest expense Taxable income Tax payable @ 30% Net income (after tax) 45,000 14,000 350 12,455 2,500 15,695 495 15,200 4,560 10,640 Further information: Sales: It is reasonable to assume that approximately 50% of sales are on credit.

In property investment analysis, ‘property’ cash flows are distinguished from ‘equity’ cash flows. Property cash flows are the equivalent of ‘project’ cash flows discussed in this chapter. Property cash flow calculations do not include loan repayments and interest charges as deductions. This approach is consistent with the general cash flow definition in this chapter. ‘Equity’ cash flow calculations, in contrast, deduct loan repayments and interest expenses. One of the objectives of property investment analysis is to evaluate the return to the investor under different debt and tax situations.

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