Evaluating

Investment
Proposals
Chapter 10
Prepared By: Elaine Precious K. Galvez
Use Free Cash Flows Rather Than Accounting Profits.
Think Incrementally
Beware of Cash Flows Diverted From Existing Products
Look For Incidental or Synergistic Effects.
Work In Working-Capital Requirements
Consider Incremental Expenses
Remember That Sunk Costs Are Not Incremental Cash Flows
Account For Opportunity Cost
Decide If Overhead Costs Are Truly Incremental Cash Flows
. Ignore Interest Payments and Financing Flows
Calculations Of A Project's
Free Cash Flows

Initial Outlay
Annual Free Cash Flows
Terminal Cash Flow
The Cash Flows
Operating Cash Flows
A. Pro forma Approach
OCF= change in earning before interest and taxes-
change in taxes + change in depreciation
B. Add Back Approach
OCF= net income+ depreciation
C. Definitional Approach
OCF= change in revenues - change in cash
expenses - change in taxes
D. Depreciation Tax Shield Approach
OCF= (revenues-cash expenses) x (1-tax rate)+
(change in depreciate x tax rate)
Cash Flows From Change in
Net Working Capital

= additional investment in working capital-

additional short term liabilities generated.

• Cash Spending Cash Flows

=difference between the capital spending

with and without the new project.
Project's Free Cash Flow
Project's change in OCF - change in net
working capital - change in capital spending

or

change in EBIT - change in taxes + change in

depreciation - change in net working capital -
change in capital spending.
 Complications in Capital
Budgeting: Capital Rationing
Capital Rationing

- Placing of a limit by the firm on the

dollar size of a capital budget
Three Reasons For Capital
Rationing Constraints
1. Management may think market conditions
are temporarily adverse.

2. There may be shortage of qualified

managers to direct new projects.

3. There may be intangible considerations.

Project Ranking

choosing of which project will increase

shareholder's wealth the most.
Mutually exclusive projects

a set of projects that perform

essentially the same task, so that
acceptance of one will necessarily
mean rejection of the others.
Problems in Project Ranking

-Size disparity problem

-Time disparity problem
-Unequal lives problem
Options in Capital Budgeting

1. Option to delay a project-to delay development and improve the

value of a project until the future cash flows are more favorable.

2. Option to expand a project-because estimated cash flow

associated change over time; it becomes more valuable to
expand.

3. Option to abandon a project-if future cash flows fall short of

expectations.