4) DCF- Further aspects

Question 1

Are interest rate and company’s WACC money or real rate?

Answer 1

Money rate. This is the default assumption

They are NOT real rates

Question 2

What is the real method

Answer 2

The real cost of capital reflects the return that investors require over and above any inflation that exists in an economy

The cash flows are expressed in “real” terms. These are cashflows with the general rate of inflation stripped out OR in current terms.

We do NOT adjust cash flows for inflation- leave them in real/current terms i.e. in today’s T0 prices; real flows.

Then Discount cash flows at REAL cost of capital (Over and above inflation- taking away inflation from the interest to give us Real Cost of Capital

Question 3

What is the money method-

• what does it reflect
• how do you calculate

Answer 3

The money cost of capital reflects the money return that investors require and includes the additional return that investors will want to compensate for inflation

Cashflows may have future inflation incorporated (“Money” or “nominal” terms)

You Inflate each cash flow by the inflation rate i.e. convert it to a money flow (using the inflation rate)

AND Discount cash flows at MONEY cost of capital.

To do this it is done by compounding. (1+Inflatin)^n

Question 4

When does the real method apply

as well as when MUST it be used

Answer 4

Only when the rate of inflation of the specific cash flows involved are the same as the general rate of inflation.

Use real for annuities and perpetuities

Remember than if there is a single rate of inflation applicable to all cash flows the NPV in real terms will equal the NPV in money term

Question 5

When does the Money method apply as well as when MUST it be used

Answer 5

When there are different rates of inflation.

If there is a question that contains both tax and inflation then use money

Question 6

What are the impacts of corporation tax

Answer 6

• operating cash inflows will be taxed at the corporation tax rate. So tax is payable on net operating profits :(
• operating cash outflows will be tax deductible and attract tax relief at the corporation tax rate :)
• investment spending attracts tax-allowable depreciation therefore reducing our profits and reduction in the tax paid :)

Question 7

..What are the default assumptions for tax?

Answer 7

• Tax is payable one year in arrears
• An asset is purchased at the beginning of an accounting period
• Net operating cash flows are taxable
• A balancing allowance or balancing charge arises in the year in which an asset is sold

Question 8

What are the steps in calculating the NPV when tax is involved?

Answer 8

Step 1) Calculate the benefit that arises from tax adjusted depreciation (reducing balance basis)

Time, WDV, Tax , Time of benefit

The tax rate is the same as the rate you pay but here it is the rate that you’re basically saving

Do not calculate the WDV for the final year

Step 2) Calculate NPV

Time across

Columns:
CF Inflows
(Tax @ _%)
(Initial Cost)
Scrap value
Benefits
= Net Cash flow
x DF

=NPV

Question 9

How do you calculate the adjustment that needs to be made to NPV calculation to reflect the amount of cash tied up in working capital

Answer 9

To make this adjustment:

1. Calculate the total amount of working capital that needs to be in place at the beginning of each accounting period
2. Calculate the net change in working capital during the accounting period

Question 10

Show the calculation of the Money method

Answer 10

Step 1) Find the money cash flows; (Compound effect)

Time, CF x (1+Inflation)^0,1,2,3 = New CF

Step 2) NPV in money terms

Time, CF x DF = NPV

Question 11

What is working capital definition and what is the assumption for investment appraisal

Answer 11

Current assets- Current Liabilities

any amount invested in WC is released at the end of the life of the project

Question 12

When there is capital required for each year, the sentencing is “WC is required in place at the start of each year equal to 10% of the cash inflow for that year”

How do you calculate for T0 for e.g.?

Answer 12

E.g. T1 is at the end of the first year or start of the second year. It is assumed to be at a fixed point in time.

Therefore if 100k is coming in at T1, the working capital required is 10% of that 100k as T0 is the start of the first year

Question 13

What is the profoma for NPV for long questions?

Answer 13

Time across

• Operating cash flows
• Inflows
• (Outflows)
• Opportunity saving/(cost)

= Net Operating cash flow before tax

• ( Taxation)

= Net Operating CF after Tax

• (Initial investment)
• Scrap proceeds
• Capital Allowances/Tax saving
• Working capital change

= Net cash flow

• x Discount factors

=NPV

Question 14

If an examiner asks for NPV calculation using the real method when there is more that one inflation value- how do you do this?

Answer 14

The technique is to inflate the cash flows to money cash flows and then deflate them at the general inflation rate.

The discount them using the real cost of capital

Question 15

If a question contains both tax and inflation, how do you work this out

Answer 15

• If necessary inflate cash flows before looking at their tax implications
• Inflate, if necessary, costs and disposal values before calculating tax allowable deprecation
• Calculate working capital based on inflated figures
• Use a post tax money rate

Question 16

If there is a resale value, how do you calculate the NPV with that informatoin?

Answer 16

you discount it as normal using the time that it takes place in

Question 17

When calculating tax allowable dedcutions, what are the rules

Answer 17

There is tax allowable depreciation on T0 if the item is bought at the beginning of the year and their year end is 31 December. That benefit is for time 1

On the final year, the balancing figure to give the scrap value is also used to work out the TAD and the saving

Question 18

project has initial outflow when bought then series of revenue at end of each year and finally proceeds when asset is sold. NPV = 12k when inflation is 0

If inflation were to rise to 7% and revenues were affected but the initial expenditure and resale were not- what will happen to NPV?

Answer 18

The NPV impact of the initial outflow is unaffected. The revenue flows will be subject to inflation, but then should be discounted at a money rate that includes this inflation. The net effect is no change in the PV. The sales proceeds represent a flow of money, not affected by inflation, but this will now be discounted at a higher money rate, lowering the net present value of the project

Question 19

Discuss the difference between a nominal (money terms) approach and a real terms approach to calculating net present value.

Answer 19

Money approach- Cash flows are adjusted to reflect inflation expected in those particular e.g. SP by 4% and VC by 5%. These CF are then discounted at a money or nominal rate- a rate which reflects inflation.

Real- CF are kept in current price (ignores inflation) or are deflated by th general rate of inflation. The CF are then discounted a real rate i.e. the rate over and above any inflation.

Whichever approach is used- NPV will be the same because nominal CF and nominal cost of capital are both discounted by the general rate of inflation to obtain real cash flow and the real cost of capital

Question 20

If the project were re-evaluated on the assumption that the cash flows were subject to a positive rate of inflation, what would be the effect on the payback period and the internal rate of return?

Answer 20

First considering payback - if the initial outflow doesn’t change but the inflows all increase as a result of inflation, then the payback period will decrease - the value of inflows increases shortening the payback period.

Just considering the effect of inflation on the internal rate of return - if inflation is now included in the cashflows, it will also be included in the rate of return (and the IRR) so the IRR becomes (1+non inflation IRR)x(1+inflation). This increases the IRR of the project.

the IRR is, by definition, that rate of interest at which the NPV is zero. If the cash inflows are higher, then the IRR must be higher to still get an NPV of zero.

Positive inflation occurs when there is a boost in consumer demand and consumption indirectly there will be an increase in cash inflow causing decrease in payback period ( period in which investment is recovered) and increasing IRR.