Chap 6 Flashcards
When applying the NPV rule, there are 4 rules that need to be applied:
- Only cash flow is relevant.
- Always estimate cash flows on an incremental basis.
- Be consistent in your treatment of inflation.
- Separate investment and financing decisions.
What is meant by only cash flow is relevant?
- Cash flow is simply the difference between cash received and cash paid out.
- Do not confuse cash flow with accounting income.
When calculating NPV, when should capital expenditures be stated?
State capital expenditures when they occur, not later when they show up as depreciation.
How do you go from accounting income to cash flow?
Need to add back depreciation (which is not a cash outflow) and subtract capital expenditure (which is a cash outflow)
What is Net Working Capital?
How is it calculated?
The difference between a company’s short-term assets and liabilities.
Short-term assets are: Accounts receivable and inventories of raw materials and finished goods
Short-term liabilities:
Accounts payable and taxes that have been incurred but not yet paid.
How should Net Working Capital be recognized in your NPV calculation?
- Each periods change in working capital should be recognized in your cash-flow forecasts
What are the most common mistakes with working capital in capital investment calculations?
- Forgetting about working capital entirely.
- Forgetting that working capital may change during the life of the project.
- Forgetting that working capital is recovered at the end of the project. When the project comes to an end, inventories are run down, any unpaid bills are paid off, and you recover your investment in working capital. This generates a cash inflow.
What does it mean to estimate cash flows on an incremental basis?
The value of a project depends on all the additional cash flows that follow from project acceptance.
When deciding which cash flows to include in your NPV calculation, what does it mean to not confuse average with incremental payoffs?
Managers tend to naturally hesitate to invest in a project following a bad investment.
When deciding which cash flows to include in your NPV calculation, what does it mean to include all incidental benefits?
Consider a project’s effects on the remainder of the firm’s business.
- it could bring additional business to the other aspects of the firm
When deciding which cash flows to include in your NPV calculation, what does it mean to forecast after-sales cash flows today?
Financial managers should forecast all incremental cash flows generated by an investment. Sometimes these incremental cash flows last for decades.
- many decisions depend on revenues that come after the investment.
When deciding which cash flows to include in your NPV calculation, what does it mean to include opportunity costs?
The cost of a resource may be relevant to the investment decision even when no cash changes hands.
ex. owning a piece of land - what would you do with the land if you don’t invest in this project?
When deciding which cash flows to include in your NPV calculation, what does it mean to forget sunk costs?
They are past and irreversible out- flows. Because sunk costs are bygones, they cannot be affected by the decision to accept or reject the project, and so they should be ignored
When deciding which cash flows to include in your NPV calculation, what does it mean to beware of allocated overhead costs?
In investment appraisal we should include only the extra expenses that would result from the project.
(NOT salaries, rent, heat, etc.)
When deciding which cash flows to include in your NPV calculation, what does it mean to remember salvage value?
When the project comes to an end, you may be able to sell the plant and equipment or redeploy the assets elsewhere in the business.
What does it mean to treat inflation consistently in a NPV calculation?
Discount nominal cash flows at a nominal discount rate. Discount real cash flows at a real rate.
Never mix real cash flows with nominal discount rates or nominal flows with real rates.
How are tax savings affected by inflation?
Tax savings from depreciation do not increase with inflation; they are constant in nominal terms
What does it mean to separate Investment and Financing decisions?
Regardless of the actual financing, you should view the project as if it were all-equity-financed, treating all cash outflows required for the project as coming from stockholders and all cash inflows as going to them.
What is the formula for straight line depreciation in year t?
Depreciation in year t = 1 / (T x depreciable amount)
How is net cash flow calculated?
Net cash flow = cash flow from capital investment and disposal + cash flow from changes in working capital
+ operating cash flow
How is operating cash flow calculated?
Operating cash flow = revenues − cash expenses − taxes
How does depreciation affect cash flow?
Depreciation is a non-cash expense; it is important only because it reduces taxable income.
- It provides an annual tax shield
How is the tax shield calculated?
Tax shield = depreciation × tax rate
In what countries can you find two vs. one book of records kept?
(separation of tax accounts from shareholder accounts)
Two books:
USA:
One has straight line dep’n - shareholders, and one has accelerated dep’n - IRS
One book:
Japan, France, and many european countries.
What are some important things to remember when calculating NPV in other countries?
- make sure they’re stated in the right currency
- use their inflation rate
- use their depreciation system
What are the problems when using the NPV rule to choose among projects?
∙ The investment timing problem.
(today’s investment is competing with possible future investments.)
∙ The choice between long- and short-lived equipment.
∙ The replacement problem. (Using equipment for another year could delay investment in more modern equipment.)
∙ The cost of excess capacity. What is the cost of using equipment that is temporarily not needed?
What is the investment timing problem?
- The investment may be more valuable if taken at a later date.
You must first examine alternative start dates (t) for the investment and calculate the net future value at each of these dates. Then, to find which of the alternatives would add most to the firm’s current value, you must discount these net future values back to the present:
What calculations should be done when choosing between long and short lived equipment?
Equivalent annual costs: EAC = ADD THIS - also remember to consider inflation - using after tax costs (Recognizing that operating costs are tax-deductible and that capital investments generates depreciation which is a tax shield)
