lecture 4: chapter 8: Net Present Value and Capital Budgeting Flashcards
Incremental cash flows
the changes in the firm’s cash flows that occur as a direct consequence of accepting the project
sunk cost
a cost that has already occurred
they cannot be changed by the decision to accept or reject the project
we should ignore such costs
opportunity costs
by taking the project, the firm forgoes other opportunities for using the assets
what you potentially forego when making an action
the side effects of the proposed project on other parts of the firm
erosion or synergy
erosion
occurs when a new product reduces the sales and, hence, the cash flows of existing products
synergy
occurs when a new project increases the cash flows of existing projects
allocated cost
cash outflow of a project only if it is an incremental cost of the project
Net working capital
the difference between current assets and current liabilities
why is working capital usually negative in the beginnings of projects?
do companies usually recover it by the end of the project?
because of assumed expansion
–> we got more working capital that we must later repay
–> funded by cash generated elsewhere in the firm
–> Hence, these increases are viewed as cash outflows
yes they do
–> all inventory is sold by the end, the cash balance maintained as a buffer is liquidated, and all accounts receivable are collected
–> decreases in working capital in the later years are viewed as cash inflows
increases in working capital in the beginnings of projects is because of what?
funded by cash generated elsewhere in the firm
–> Hence, these increases are viewed as cash outflows
a firm’s management generally keeps which two sets of books
one for the CRA (called the tax books)
one for its annual report (called the shareholders’ books)
when does an investment in net working capital arises?
(1) raw materials and other inventory are purchased prior to the sale of finished goods
(2) cash is kept in the project as a buffer against unexpected expenditures
(3) credit sales are made, generating accounts receivable rather than cash
–> This investment in net working capital represents a cash outflow, because cash generated elsewhere in the firm is tied up in the project
the real interest rate
interest rate with inflation
real rate = (1 + nominal rate)/(1 + inflation rate) - 1
or it is approximately nominal rate - inflation rate
–> only works when the percentages are low
nominal interest rate
no inflation considered
when is a cash flow expressed in nominal terms?
whenthe actual dollars to be received (or paid out) are given
when is a cash flow expressed in real terms?
when the current or date 0 purchasing power of the cash flow is given
future cash flow / (1 + inflation rate)^n
Nominal cash flows must be discounted at which rate?
the nominal interest rate
real cash flows must be discounted at which rate?
the real interest rate
the bottom-up approach for operating cash flow
when is is only acceptable to use this?
find the net income, and then add back any non-cash deductions such as depreciation
only if there is
no interest expense subtracted in the calculation of net income
the top-down approach for operating cash flow
Begin with the top of the comprehensive statement of income with sales, and work down to net cash flow by subtracting costs, taxes, and other expenses
Along the way, simply leave out any strictly non-cash items such as depreciation
the tax shield approach for operating cash flow
(sales - costs) · (1 - tax rate) + Depreciation · tax rate
the depreciation tax shield
Depreciation · tax rate
Knowing that depreciation is a non-cash expense, the only cash flow effect of deduct- ing depreciation is to reduce our taxes.
the equivalent annual cost (EAC)
when we must choose between different projects, or equipment, or other expenses that have different lifespan (hence some have more outflows than others)
his approach puts costs on a per year basis
–> find the annuity per for the mount of years necessary equal to the PV of total cash outflows
