Chapter 5 Flashcards
General rule
Only those cash inflows and outflows which are affected by a decision are relevant to the decision.
This means using only future, incremental cash flows.
Incremental cash flows are those that change because a project is undertaken (e.g. cash from sales, less operating costs such as materials and labour).
Do not include financing cash flows because the cost of finance is measured in the cost of capital/discount rate (i.e. finance costs are taken into account by the discounting process). This means using only future, incremental cash flows.
Costs that should be specifically excluded
sunk costs (i.e. money already spent);
non-cash costs (e.g. depreciation);
book values (e.g. FIFO/LIFO inventory values);
unavoidable costs (i.e. money already committed and apportioned fixed costs); and
finance costs such as interest.
However, include all opportunity costs and revenues. For example, where there is “cannibalisation” (i.e. where the launch of a new product will reduce the sales of an existing product), the lost contribution is an opportunity cost and should be shown as a cash outflow.
Pre tax cash flow formula
Pre-tax cash flow = Post-tax cash flow/(1 − Corporate tax rate)
Pre tax discount rate formula
Pre-tax discount rate = Post-tax discount rate/(1 − Corporate tax rate)
Problems caused by infation
It is hard to estimate, especially when rates are high.
It causes governments to take actions which may affect businesses (e.g. raising interest rates, cutting state spending).
Different costs and revenues will inflate at different rates.
It alters the cost of capital (in nominal terms).
It makes historic costs irrelevant and therefore causes return on capital employed (ROCE) to be overstated.
It creates uncertainty for customers, which may lead to lower demand.
It encourages managers to become short term in outlook.
Real rate of interest
The real rate of interest reflects the rate of interest which would be required in the absence of inflation. The market rate quotes a real rate of interest.
Nominal rate of interest
The nominal rate of interest reflects the real rate of interest adjusted for the effect of general inflation as measured,
General and specific inflation rates
A specific inflation rate is the rate of inflation on an individual item (e.g. wage inflation, materials price inflation). In comparison, the general inflation rate is a weighted average of many specific inflation rates.
Real method
Cash flows are expressed at today’s prices (i.e. before the effects of inflation). These are then discounted at a real rate excluding general inflation. Use the Fisher formula (see above) if necessary to calculate a real rate from a nominal (or money) rate and the general inflation rate.
This method only works if ALL cash flows are inflating at the same general rate of inflation.
How are cash flows derived
Increase in net working capital = cash outflow
Decrease in net working capital = cash inflow
Problems caused by inflation
It is hard to estimate, especially when rates are high.
It causes governments to take actions which may affect businesses (e.g. raising interest rates, cutting state spending).
Different costs and revenues will inflate at different rates.
It alters the cost of capital (in nominal terms).
It makes historic costs irrelevant and therefore causes return on capital employed (ROCE) to be overstated.
It creates uncertainty for customers, which may lead to lower demand.
It encourages managers to become short term in outlook.
How to protect against inflation
Over the life of a project, the effect of general inflation would be to erode the real value of any initial investment in working capital.
To protect against this requires subsequent nominal increases in the level of working capital, with these incremental investments creating related cash outflows.
