week 4 Flashcards
what is the assumption for NPV? and why is this not true in real life?
it was assumed that a project’s cash flows and the discount rate applicable to those cash flows were both known
In practice, a project’s cash flows and required rate of return are not known with certainty but must be estimated involving an estimation of cash flows and risk.
In calculating a project’s net cash flows,
it is the incremental net cash flows that are important.
Incremental cash flows
in calculating cash flows, an analyst should
Consider any and all changes in the firm’s future cash flows that are a direct consequence of undertaking the project.
nTo determine incremental cash flows, ask two questions:
what decision do you make?
- Is it a cash item?
- Will the amount of the item change if the project is undertaken?
If the answer to both questions is ‘yes’, then the item is an incremental cash flow. If the answer to either question is ‘no’, then the item is irrelevant to the analysis.
describe sunk costs
Sunk costs are costs that have been or will be paid regardless of the decision whether or not the investment is undertaken.
Sunk costs should not be included in the incremental earnings analysis.
Fixed Overhead Expenses
Typically overhead costs are fixed and not incremental to the project and should not be included in the calculation of incremental earnings.
in identifying cash flows, you will have to identify sunk costs
describe
na cost that has already been incurred and cannot be removed so it’s NOT an incremental cash flow
spent $20 million exploring a particular area without success. Harvey Mills, the geologist who originally identified that area as potentially valuable, argues that the company should spend another $5 million to drill an additional well because: ‘If we don’t, the $20 million that we have already spent will be lost’.
In this case, the $20 million has already been spent. This figure will not change if the project is continued or abandoned. Allowing sunk costs to influence decisions can lead to ‘throwing good money after bad’. Regardless of whether $2 or $20 million has already been spent, decisions on whether to continue a project should be based only on expected future costs and benefits.
relevant cash flows
Describe opportunity costs
the most valuable alternative that is given up by the investment = incremental cash flow
Relevant Cash Flows
Side effects
Side effects Þ erosion = incremental cash flow
Relevant cash flows
Financing costs
incorporated in discount rate so not part of incremental cash flow
for incremental cash flow, what do u always use?
Always use after-tax incremental cash flow
give an example of opportunity cost
evaluating a new factory to be built on an existing piece of land
Opportunity cost would be the foregone cash flow from the best use of land if the factory was not built.
e.g. To use as a car park, storage facility, etc.
Relevant cash flows: Indirect Effects on Incremental Earnings
What about project externalities?
what is cannibalization?
Indirect effects of the project that may affect the profits of other business activities of the firm. Cannibalization is when sales of a new product displaces sales of an existing product.
describe what impact NPV has on interest cost
As the project’s NPV is positive, the cash flows from the investment will cover interest costs (as long as the interest cost is less than the required rate of return).
-Interest costs should not therefore be included as an explicit cash flow.
-Interest costs are included in the required rate of return (discount rate) used to evaluate the project.
Depreciation itself is
¡a non-cash expense; consequently, it is only relevant because it affects taxes.
Depreciation tax shield = Dt, where D = depreciation expense and t = marginal tax rate
depreciation of non-current assets, excluding land and, in some cases, buildings, is
depreciation of non-current assets, excluding land and, in some cases, buildings, is
when an asset’s disposal value/savlage value < book value/written down value
a loss on sale, which is tax deductible. This tax saving is treated as a cash inflow
the ensuing loss on disposal is a income tax deduction (insufficient depreciation in previous periods)
If salvage value/asset’s disposal value > book value
the gain on sale of $50 000 is regarded as recovery of depreciation deductions that were previously claimed.
a profit/gain is made on disposal. This profit/gain is subject to income tax (excess depreciation in previous periods).
Disposal of Assets (capital gain tax)
Capital gains made on the sale of assets such as rental property are subject to taxation.
Capital losses are not a tax deduction but can be offset against future capital gains.
why may you want to Replace or Retire a Project
Investment projects are not always continued until the end of their estimated physical lives and, , the systematic search for new investments should be complemented by a periodic review of the performance of existing projects. Such reviews may result in decisions to retire (abandon) assets or to replace existing assets.
describe retirement decisions
Retirement decisions involve those situations where assets are used for some time, and then it is decided not to continue the operation in which the assets are used. Therefore, the assets are sold and not replaced.
describe replacement decisions
involve those situations where a particular type of operation is intended to continue indefinitely—that is, a company’s need for the assets is assumed to continue long after the present assets have been sold or scrapped.
company is faced with a decision about when its existing assets should be replaced.
what can be used to determine if a project should be retired?
Since the retirement of assets is just another investment decision, the net present value rule is still valid for retirement decisions
a project should be retired if the net present value of all its future net cash flows is less than zero.
replacement decsions
describe identical replacement
current project will be replaced by a project identical in every respect. The capital outlay, net cash flows, physical life and residual value of both projects are the same.
describe:Mutually Exclusive Projects with Different Lives
nThe situation:
¡One project may end before the other.
¡They are mutual exclusive
¡They are not one-off projects but are likely be replaced (or continued) by other similar projects
describe constant chain of replacement assumption
may be used to evaluate mutually exclusive projects of unequal lives; in this case, each project is assumed to be replaced at the end of its economic life by an identical project
A valid comparison of two chains of replacement can be made only when both chains are of equal length
what are two approaches to comparing mutually exclusive projects with different lives?
- constant chain of replacement assumption
- Make assumptions about the reinvestment opportunities that will become available in the future.
Constant chain of replacement assumption can be used to compare mutually exclusive projects with different lives by
- Lowest common multiple method
- constant chain of replacement in perpetuity
- equivalent annual value method.
disadvantage of lowest common multiple method
can be cumbersome
describe the constant chain of replacement in perpetuity
assume that both chains continue indefinitely. In this case the ‘lengths’ of the chains are ‘equal’ in the sense that they are both infinite
Chain of replacement methods and inflation
The chain of replacement method assumes that it will be replaced by an identical project at the end of the project’s life.
Clearly, if there is inflation, nominal cash flows will not be the same
To ensure that inflation is treated consistently, all cash flows and the required rate of return should generally be expressed in real terms when a chain of replacement method is used
Is the Constant Chain of Replacement Method Realistic?
The assumption that the machines replaced and the services they provide are identical in every respect is unrealistic.
what reduces the impact of the unrealistic assumption about the chain of replacement method
the fact that the replacements may be many years in the future, and the fact that their cash flows will be discounted to a present value, reduces the impact of making such unrealistic assumptions
what reinforces the unrealistic assumption about the constant chain of replacement method?
It may be even more unrealistic to assume that management has sufficient foresight to be able to predict such factors as the capital outlay, net cash flows, life and residual value of replacement assets
The different lives ‘problem’ arises only for
mutually exclusive projects
Effect of risk on the value of a project is
reflected by the required rate of return
How do we factor in variability in forecasting cash flows?
Through the use of:
¡Sensitivity analysis
¡Break-even analysis
¡Simulation techniques
describe sensitivity analysis
Analyses effect of changing one or more input variables to observe the effects on the results (similar to ‘what if we changed …?’).
assessing the effect of changes or errors in the estimated variables on the net present value of a project.
what is the benefit of knowing NPV’s sensitivity to variables?
Knowledge of the sensitivity of net present value to changes or errors in the variables places management in a better position to decide whether a project is too risky to accept.
Also, if management knows that the net present value is sensitive to changes in particular variables, it can examine the estimates of these variables more thoroughly, or collect more data in an effort to reduce errors in forecasting
describe the first step of sensitivity analysis
- Pessimistic, optimistic and expected estimates made
for each variable. - NPV is calculated using expected estimates for each variable except one. Procedure repeated using the optimistic and pessimistic estimates of each variable.
- Difference between pessimistic and optimistic NPV
is calculated for each variable.A small difference between the net present values suggests that the project’s net present value is insensitive to changes or errors in that variable. A large difference between the net present values suggests the opposite.
