Chapter 9 - Using Discounted Cash flows to make investment decisions

Question 1

NPV steps of the process

Answer 1

Step 1: forecast cash flows
Step 2: Estimate discount rate
Step 3: Perform a sensitivity analysis

Question 2

Cash flows rules

Answer 2

• discount incremental cash flows: forecast the firm’s cash flow if you proceed with the project - without
• include all indirect effects: to forecast incremental cash flow, you must trace out all indirect effects of accepting the project
• forget sunk costs: sunk costs remain the same whether or not you accept the project so they don’t affect NPV of a project
• include opportunity costs: equals the cash that could be realized from selling the land now, and therefore is relevant cash flows for project evaluation

-recognize the investment in working capital: net working capital = firm’s current assets - current liabilities
most project entail an additional investment in working capital

• remember shutdown cash flows: a project may generate overhead costs but then again it may not.
• allocated overhead costs: include only the incremental overhead expenses which would result from the project
• treat inflation consistently: be consistent with the rate used
• seperate investment and financing:
  when calculating the cash flows from a project ignore how the project is to be financed

Question 3

components of total cash flow

Answer 3

• cash flow from investment in plant and equipment (capital investment)
• cash flow from investment in working capital
• cash flow from operations

Question 4

cash flow from Investment in PPE

Answer 4

• all cash flows associated with capital investment should be included
• involves an initial outlay (outflow) today and a salvage value (inflow) at the end

Question 5

cash flow from investment in WC

Answer 5

• include all incremental cash flows associated with working capital
• WC are recovered at the end of the project’s life
• initial outlay today and recovery at the end
• an increase in current assets represents a use of cash and is a cash outflow
• an increase in current liabilities is a source of cash and is an inflow

Question 6

cash flow from operations

Answer 6

• many investments do not result in additional revenues but may reduce costs => cost savings represent positive operation cash flows
• depreciation is a non-cash expense and should not be deducted when calculating operating cash flows

Question 7

business taxes in canada

Answer 7

• when calculating taxable income, a company may deduct an amount for depreciation: the write-off amount is = capital cost allowance, the balance that has not been yet depreciated is called the undepreciated capital cost (UCC)
• tax savings arrising from CCA = CCA tax shield
• for calculating CCA, assets are assigned to different assets classes

Question 8

Rates used to classify CCA

Answer 8

• intangible assets use a straight-line depreciation method
• most asset classes use the declining balance method
• when computing NPV, calculate the PV of operating cahs flows separately from the PV of the CCA tax shields

Question 9

half year rule def

Answer 9

only one half of the purchase cost of the asset is added to the asset class and used to compute CCA in the year of purchase

Question 10

Estimate discount rate

Answer 10

the discount rate used to calculate NPV must reflect the risk of the cash flows being discounted

Question 11

sensitivity analysis

Answer 11

NPV model is built on assumptions

• what-if analysis crucial to ensuring model is robust