Chapter 8 - Releveny Cash Flows For DCF

Question 1

What is this chapter about ?

Answer 1

This chapter examines how to establish the cash flows of investments in order to be then able to apply the discounted cash flow

The general rule is that we are interested in the future, incremental cash flows to the company as a result of undertaking the investment

Question 2

What costs are we not interested in when considering undertaking the investment

Answer 2

Sunk costs
Historic costs
Non cash flows (eg depreciation)
Book values
Interest costs (as these are dealt with in discounting)

Question 3

What costs are we interested in regarding the cash flows for investments

Answer 3

Direct and opportunity cash costs and revenues

Question 4

What 3 problems will we encounter and have to deal with in this chapter

Answer 4

Working capital
Taxation
Inflation

Question 5

How to deal with working capital

Answer 5

Consider it a cost in year 0 and assume it comes back so add it as revenue in final year as we assume it is to buy inventory and therefore it’s comes to fruition

Question 6

Why is tax important in relevant cash flows for discount cash flows ?

Answer 6

If we do new project and earning more so profits increase so we pay more taxes and taxes are a cash flow

Question 7

How do we deal with the tax (corporation tax and not VAT)

Answer 7

Like with cash flows we set up the table like

0 1 2 3 4

And you start with net cash and you calculate the corporate tax from that. However we also have capital allowance which we normally deduct off the net cash to arrive at the tax amount however that can get messy here so instead we calculate the tax on the full net cash and add a savings amount off the tax amount.

Let’s say net cash is 1000, capital allowance is 200 and CT is 30% rather than do 1000-200 = 800 @ 30% we do 1000 @ 30% = 300 less 200@30% = 240

Question 8

How to deal with capital allowances

Answer 8

Imagine the question said capital allowances of 25% in reducing balance this means for example that if the investment cost 10,000 then first year we would have a saving of 10,000 x 25% @ 30% = 750 and the next year you do the same on the remaining 7500. In the year of the sale you take the sales proceeds less the remaining amount left of allowance and depending either repay or save the difference @ 30%

Question 9

Is there tax on working capital ?

Answer 9

No don’t calculate tax on working capital, leave it to the end of the cash flows table

Question 10

How does inflation work in cash flows

Answer 10

It’s easy to add on the inflation % just be careful with ‘current prices’ if it says current material price is £8 and increase next year by 8% then the first year would be 8.64 and not 8

Question 11

What is the full order to do the cash flows

Answer 11

0 1 2 3
Operating cash flows;
Revenue
Materials ()
Labour ()
Fixed o’h ( only relevant if extra not absorbed as not relevant cost)

Total together = net operating flows

Tax (if arrears move to next month)

Capital flows;
Cost in year 0 ()
Scrap
Tax saving on capital allowances (in arreas if tax is in arreas)

Working capital (outflow at start of project and inflow at end of project unless says cash flows are indefinite then only put inflow at start)

Add all together

Calculate NPV

Remember to say if they should accept or decline project!!

Question 12

What reservations could there be

Answer 12

Are rates of inflation correct
Can we sell it for scrap at price quoted
Are sales totals each year correct
Etc

Question 13

What is a different word for actual

Answer 13

Nominal

Eg actual cash flows = nominal cash flows

Actual cost of capital = nominal cost of capital

Question 14

What are “real cash flows”

Answer 14

Discount cash flows ignoring inflation

Question 15

What is “real cost of capital”

Answer 15

At cost of capital if no inflation

Question 16

What are the nominal cash flows

Answer 16

Nominal means actual so what is the actual cash flows, to do this calculate with inflation

Question 17

What to calculate inflation in the real rates

Answer 17

The real rates are without inflation. When inflation goes up so does the interest and visa Cerda do to remove inflation (real rates) there is a formula

1 + r = (1 +r) x (1+h)

i = actual cost of capital (nominal rate)
r = the real cost of capital
h = the general inflation rate

Imagine the cost of capital is 15% and inflation rate is 5% so to work out the real cost (r)

1.15 = (1 + r) x 1.05
1 + r = 1.15/1.05 = 1.0952
R = 0.0952 or 9.52%

So use this new % as the new cost of capital so by removing the inflation the % reduces

Question 18

When can you use the real rates of inflation

Answer 18

Only when inflation is the same for all items (e.g can’t be if material inflates at 5% and labour at 8%)

Times to use this method;

1.When asked in question to do it that way

2. If in perpetuity - imagine 10,000 at current prices in perpetuity, inflation is 4% pa and cost of capital is 12%. We couldn’t use the other approach as be there forever. So need to strip out the inflation and use inflation. Therefore;

1+r = 1.12 /1.04 = 7.69%
10,000 x 1 / 0.769 = £130,000

3. Where question says “real cost of capital 10% and inflation @ 3 %”

I + I = 1.1 x 1.03 = 1.1333
I = 0.133%

Approximate, use tables at 13%