Lecture 6

Question 1

What is the difference between cash flows in appraisal and financial statements?

Answer 1

In appraisal, only actual cash flows that occur are considered, while financial statements include both real cash flows and adjustments like depreciation.

Question 2

Why is depreciation not considered a cash flow in investment appraisal?

Answer 2

Depreciation is not a cash flow; instead, capital allowance is used to reduce taxable amounts in appraisal.

Question 3

How should time units be handled in NPV calculations?

Answer 3

Cash flows and discount rates must be consistent with time units. If the rate of return kkk is annual, then time ttt should be in years.

Question 4

What happens if monthly cash flows are treated as annual in NPV calculations?

Answer 4

Treating monthly cash flows as annual can lead to heavy discounting, which affects the NPV and can favor a project that should be rejected.

Question 5

What are the two ways of presenting cash flows in the context of inflation?

Answer 5

Cash flows can be presented in nominal terms (including inflation adjustments) or real terms (in today’s prices).

Question 6

What should be consistent when working with real or nominal cash flows?

Answer 6

Consistency is required in whether all calculations are done in real terms or nominal terms, including both cash flows and discount rates.

Question 7

How do you compare machines with different life spans for replacement decisions?

Answer 7

Question 8

What is opportunity cost in the context of investment appraisal?

Answer 8

Opportunity cost is the potential income lost from not using a resource for its best alternative use, even if no actual cash payment is made.

Question 9

Should overhead costs be included in project appraisal?

Answer 9

Only genuinely increased costs due to the project (incremental costs) should be included, not fixed overhead costs.

Question 10

Are financing costs included in the NPV analysis?

Answer 10

No, financing costs like interest payments are not included in the cash flows for NPV analysis, as the discount rate already accounts for the cost of financing.

Question 11

How should cash flows be associated with times in NPV calculations?

Answer 11

Cash flows should be consistently associated with the times they occur, such as annually, quarterly, or monthly, matching the discount rate’s time unit.

Question 12

Why must monthly cash flows be discounted using a monthly rate of return?

Answer 12

Monthly cash flows should be discounted using a monthly rate of return because using an annual rate without converting it to a monthly rate would result in incorrect NPV calculations.

Question 13

What is the formula to convert an annual rate to a monthly rate?

Answer 13

The formula to convert an annual rate (kak_aka​) to a monthly rate (kpk_pkp​) is: 1+kp=(1+ka)p1+k_p = (1+k_a)^{p}1+kp​=(1+ka​)p, where ppp is the period in terms of a year (e.g., 1 month = 1/12 year).

Question 14

How does heavy discounting of cash flows affect investment decisions?

Answer 14

Heavy discounting of cash flows increases NPV when delayed cash flows are outgoings, favoring projects that might otherwise be rejected, and disadvantages when pushed-back cash flows are incomes.

Question 15

What are the implications of ignoring time units in cash flow analysis?

Answer 15

Ignoring time units, such as treating monthly cash flows as annual, can lead to inaccurate NPV calculations, resulting in potentially wrong investment decisions.

Question 16

What is the impact of inflation on cash flow presentation in finance?

Answer 16

Inflation impacts cash flow presentation by requiring adjustments either in nominal terms, where forecast cash flows include inflation adjustments, or in real terms, where cash flows are stated in today’s prices.

Question 17

How does one ensure consistency in real or nominal terms during NPV calculations?

Answer 17

Consistency is ensured by applying either real or nominal terms uniformly to all elements, including cash flows and discount rates, to avoid calculation errors.

Question 18

What is the relationship between nominal and real discount rates?

Answer 18

The relationship is: (1+kn)=(1+kr)(1+i)(1 + k_n) = (1 + k_r)(1 + i)(1+kn​)=(1+kr​)(1+i), where knk_nkn​ is the nominal discount rate, krk_rkr​ is the real discount rate, and iii is the inflation rate.

Question 19

How do you determine which machine to choose between options with different costs and life cycles?

Answer 19

To determine which machine to choose, calculate the equivalent annual rent for each machine, and select the one with the lower annual rent.

Question 20

What is the general formula for the equivalent annual cost (EAC) of a machine?

Answer 20

The EAC is calculated using the formula: EAC=PVcostsannuityfactorEAC = \frac{PV_{\text{costs}}}{\text{annuity factor}}EAC=annuityfactorPVcosts​​, where PVcostsPV_{\text{costs}}PVcosts​ is the present value of all costs and the annuity factor is based on the required rate of return kkk and the machine’s life span.

Question 21

How do overhead costs affect project appraisal?

Answer 21

Overhead costs affect project appraisal depending on whether they are incremental costs due to the project. Only the increased costs should be included in the appraisal.

Question 22

What is the role of financing costs in NPV analysis?

Answer 22

Financing costs, such as interest payments on loans, are not included in the NPV analysis because the discount rate already incorporates the cost of financing.

Question 23

Why does heavy discounting of cash flows lead to an increased NPV?

Answer 23

Heavy discounting of cash flows leads to an increased NPV when the delayed cash flows are outflows, such as costs or expenses. Here’s why:

Discounting and Time Value of Money: In NPV calculations, future cash flows are discounted to reflect their present value, based on the principle that money available now is worth more than the same amount in the future.

Impact on Outflows: When cash outflows (like costs) are pushed further into the future and heavily discounted, their present value decreases significantly. This means that these future costs have a lower negative impact on the overall NPV.

Increased NPV: Since NPV is the difference between the present value of inflows (revenues) and outflows (costs), reducing the present value of outflows increases the NPV. This can make a project appear more attractive, even if it would otherwise be less favorable if the costs were not delayed.

This effect, however, can be misleading. It might make a project seem more profitable than it truly is if the discounting causes significant distortion between the true timing and value of cash flows.