1.) Should you focus on cash flows or accounting profits in making the capital-b

Question

1.) Should you focus on cash flows or accounting profits in making the capital-budgeting decision? Should you be interested in incremental cash flows, incremental profits, total free cash flow, or total profits? 2.) How does depreciation affect free cash flow? 3.) How do sunk costs affect the determination of cash flows? 4.) What is the project’s initial outlay? 5.) What are the differential cash flows over the project’s life? 6.) What is the terminal cash flow? 7.) Draw a cash-flow diagram for this project. 8.) What is its net present value? 9.) What is its internal rate of return? 10.) Should the project be accepted? Why or why not? 11.) How does Genesis 47:18-19 relate to this project and cash flow management?

Explanation / Answer

1.) We focus on free cash flows rather than accounting profits because these are the flows that the firm receives and can reinvest. Only by examining cash flows are we able to correctly analyze the timing of the benefit or cost. Also, we are only interested in these cash flows on an after tax basis as only those flows are available to the shareholder.

2.) Depreciation affects cash flow by reducing the amount of cash a business must pay in Income Taxes.

3.) When evaluating a capital budgeting proposal, sunk costs are ignored. We are interested in only the incremental after-tax cash flows, or free cash flows, to the company as a whole. Regardless of the decision made on the investment at hand, the sunk costs will have already occurred, which means these are not incremental cash flows. Hence, they are irrelevant.

4.) Initial Outlay = Cost of New Plant + Installation Costs + Increase in Working Capital.

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