Relevant Cash Flows (2) Flashcards
Why is inflation a problem for project appraisal?
Hard to estimate
Makes historic costs irrelevant
Creates uncertainty for customers
What must be distinguished with inflation
Real and nominal interest rates
What is a specific inflation rate?
The rate of inflation on an individual item
What is a general inflation rate?
A weighted average of many specific inflation rates
Nominal method of cash flows?
Cash flows are inflated to future price levels using the specific inflation rate for each type of revenue/cost
What does nominal method produce?
A forecast of the physical amount of money that the company will receive or pay on the relevant future date
What to use for calculating cash flows via real method?
The fisher formula
What is the real method?
Cash flows are expressed at today’s prices (i.e. before the effects of inflation)
If selling prices and costs have different inflation rates?
The only way to accurately calculate NPV is to forecast each cash flow in nominal terms
Only situation which real method is valid?
When revenues and costs all increase at the general inflation rate
Start-up with a project?
Starts with a cash outflow for the investment in non-current assets (e.g. plant and equipment)
What do many projects require at start-up?
An investment in net current assets
How is cash flow calculated in startup?
Change in level of inventory + accounts receivable - accounts payable
What happens over the life of the project (receivables)?
The level of accounts receivable may rise, with the result that cash inflows are less than the sales revenues
What happens over the life of the project (payables)?
The level of accounts payable also may rise, reducing the required investment in working capital and improving the cash flows
Why does increasing accounts payable improve cash flows?
Since payments to suppliers are below the level of purchases
What may happen at the end of a project? (inventory and receivables)
The inventory levels may be reduced to zero and all receivables may be collected, creating a cash inflow
Increase in net working capital?
Capital outflow
Decrease in net working capital?
Capital inflow
What is assumed with changes in level of working capital?
It has no tax effects
What if artificially short time period is used?
Care is needed regarding scrap value, working capital recovery and tax in order to avoid sub-optimal decisions
How is scrap value included?
The evaluation of a project as a cash inflow at the end of the project life
Issue with ignoring scrap value?
Reduce the NPV and may lead to rejection of an otherwise acceptable investment project
Should working capital recoverry be included?
As a cash inflow shown at end of the project
Assumption in an investment in working capital?
It is “released” at the end of the project’s life
If a tax is paid one year in arrears for a four-year time horizon?
Tax charged on the fourth year’s profit should be shown as a cash outflow at the end of the fifth year
