Cash flow and capital budgeting (Chapter 8)

Question 1

Incremental cash flows

Answer 1

• Cash slows matter - not accounting earnings
• Incremental cash flow matters
  - Sunk costs dont matter
  - Opportunity costs dont matter
  - Side effects like synergy, cannibalism and erosion matters
  - Taxes matter - we want incremental after tax cash flows
• Inflation matters
• Intrest matters (affects taxes)

Se 8.1 i sammendrag fra drive for mer info.

Question 2

Operational cash flow (OCF)

Answer 2

After the initial investment, the project/company is dependent on the operational cash flow (OCF) from its investment.

Regular Approach
* OCF = EBIT – Taxes + Depreciation
(EBIT = Earnings before interest and taxes)
Can also be calculated using:

Bottom-Up Approach
Works only when there is no interest expense
* OCF = Net Income + depreciation

Top-Down Approach
* OCF = Sales – Costs – Taxes
Don’t subtract non-cash deductions

Tax Shield Approach
* OCF = (Sales – Costs)(1 – T) + Depreciation*T

Question 3

Equivalent Annual Cost (EAC)

Answer 3

Question 4

Fisher equation

Answer 4

The relationship between interest rates and inflation.
(1 + Nominal Rate) = (1 + Real Rate) × (1 + Inflation Rate)

For low rates of inflation, this is often approximated:
Real Rate = Nominal Rate – Inflation Rate

A nominal cash flow refers to the actual dollars to be received (or paid out).
A real cash flow refers to the cash flow’s purchasing power (thus equal to the nominal cash flow adjusted by inflation)

Question 5

Investments of unequal lives

Answer 5

There are times when the NPV rule can lead to wrong investment. When the lifespan of companies are unequal, we must compate them by looking at their annual cost over an equal period. There are two methods:

Using a replacement chain, where the projects are repeated until they start and end at the same time. Then you can compute the NPV for the repeated projects.

Calculate the Equivalent Annual cost