Relevant Cash Flows (2)

Question 1

Why is inflation a problem for project appraisal?

Answer 1

Hard to estimate

Makes historic costs irrelevant

Creates uncertainty for customers

Question 2

What must be distinguished with inflation

Answer 2

Real and nominal interest rates

Question 3

What is a specific inflation rate?

Answer 3

The rate of inflation on an individual item

Question 4

What is a general inflation rate?

Answer 4

A weighted average of many specific inflation rates

Question 5

Nominal method of cash flows?

Answer 5

Cash flows are inflated to future price levels using the specific inflation rate for each type of revenue/cost

Question 6

What does nominal method produce?

Answer 6

A forecast of the physical amount of money that the company will receive or pay on the relevant future date

Question 7

What to use for calculating cash flows via real method?

Answer 7

The fisher formula

Question 8

What is the real method?

Answer 8

Cash flows are expressed at today’s prices (i.e. before the effects of inflation)

Question 9

If selling prices and costs have different inflation rates?

Answer 9

The only way to accurately calculate NPV is to forecast each cash flow in nominal terms

Question 10

Only situation which real method is valid?

Answer 10

When revenues and costs all increase at the general inflation rate

Question 11

Start-up with a project?

Answer 11

Starts with a cash outflow for the investment in non-current assets (e.g. plant and equipment)

Question 12

What do many projects require at start-up?

Answer 12

An investment in net current assets

Question 13

How is cash flow calculated in startup?

Answer 13

Change in level of inventory + accounts receivable - accounts payable

Question 14

What happens over the life of the project (receivables)?

Answer 14

The level of accounts receivable may rise, with the result that cash inflows are less than the sales revenues

Question 15

What happens over the life of the project (payables)?

Answer 15

The level of accounts payable also may rise, reducing the required investment in working capital and improving the cash flows

Question 16

Why does increasing accounts payable improve cash flows?

Answer 16

Since payments to suppliers are below the level of purchases

Question 17

What may happen at the end of a project? (inventory and receivables)

Answer 17

The inventory levels may be reduced to zero and all receivables may be collected, creating a cash inflow

Question 18

Increase in net working capital?

Answer 18

Capital outflow

Question 19

Decrease in net working capital?

Answer 19

Capital inflow

Question 20

What is assumed with changes in level of working capital?

Answer 20

It has no tax effects

Question 21

What if artificially short time period is used?

Answer 21

Care is needed regarding scrap value, working capital recovery and tax in order to avoid sub-optimal decisions

Question 22

How is scrap value included?

Answer 22

The evaluation of a project as a cash inflow at the end of the project life

Question 23

Issue with ignoring scrap value?

Answer 23

Reduce the NPV and may lead to rejection of an otherwise acceptable investment project

Question 24

Should working capital recoverry be included?

Answer 24

As a cash inflow shown at end of the project

Question 25

Assumption in an investment in working capital?

Answer 25

It is “released” at the end of the project’s life

Question 26

If a tax is paid one year in arrears for a four-year time horizon?

Answer 26

Tax charged on the fourth year’s profit should be shown as a cash outflow at the end of the fifth year