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Flashcards in Chapter 9 Deck (9):

Identifying cash flows

To calculate NPV you must Discount cash flows not profits

When calculating NPV recognise investment expenditures when they occur not later when they show up as depreciation. Projects are financially attractive because of the cash they generate, either for distribution to shareholders or for reinvestment in the firm. Therefore the focus of capital budgeting must be on cash flow, not profit


Discount incremental cash flows

Incremental cash flow =
cash flow with project - cash flow without project

1)Include all indirect effects-to forecast incremental cash flow you must trace out all indirect affects of accepting the project

2)Forget sunk costs - sunk costs remain the same whether or not you accept the project, therefore they do not affect NPV

3)Include opportunity costs - benefit or cash flow forgone as a result of an action
-The opportunity cost equals the cash that could be realised from selling the land ; you lose that cash if you take the project

4)Recognise the investment capital - current assets minus current liabilities. Often called working capital
-Investments in working capital,just like investments in plant and equipment, result in cash outflows
Mistakes commonly made :
Forgetting about working capital completely
Forgetting that working capital may change over the life of the project
Forgetting that working capital is recovered at the end of the project(generates cash inflow)

5)remember terminal cash flows - end of a project will bring additional cash flows - selling a plant, may also be costs e.g. shutting down a nuclear power plant

6) beware or allocated overhead costs- (heat,electricity etc) may not be related directly to a project but must be paid, principle for incremental cash flows says that in investment appraisal we should inclufe only the extra expenses of a project

- a project may generate extra overhead costs,but then again it may not. We should be cautious about assuming that the accountants allocation of overhead costs represents the incremental cash flow that would be incurred by accepting the project


Discount nominal cash flows by the nominal cost of capital

Cannot mix and match real and nominal quantities. Real cash flows must be discounted at real discount rate, nominal cash flows at nominal rate . Discounting real cash flows at nominal rate is a big mistake

Real rate of interest (approximately equal to) - nominal rate of inflation - inflation rate

1+real rate of interest = 1+ NRI/1+inflation rate =


Separate investment and financing decisions



Calculating cash flow

Element 1

Total cash flow = cash flow from capital investments + operating cash flows + cash flows from changes in working capital

1) capital investment - to get a project off the ground a company will typically have to make a considerable upfront investment - initial investment is an outflow and then once the project is being sold they can sell the plant for an inflow


Calculating cash flow element 2

operating cash flow

Operating cash flow = revenues -costs -taxes

When firms calculate taxable income they must take into account depreciation, when working out a projects cash flows, there are three methods to calculate depreciation :

1) dollars in minus dollars out - revenues - cash expenses - taxes , take only items from the income statement that represent actual cash flows. Do not subtract the charge for depreciation as it does not involve cash going out of the door.

2) adjusted accounting profits- after tax profit + depreciation, (after tax accounting profits + non cash accounting expenses, specifically the de deduction)

3) add back depreciation tax shield -
Dep tax shield = tax rate x depreciation

Operating cash flow - (revenues - cash expenses) X (1- tax rate ) + (tax rate x depreciation )

First calculate net profit (assuming zero depreciation and then add the tax shield


Element 3

Changes in working capital

When a company builds up inventories of raw materials or finished products, the companies cash is reduced

Reduction in fins cash reflects the firms investment in inventories

Furthermore cash is low when customers take long to pay bills

Investment in working capital represents a negative cash flow
On the other hand when inventories are sold off and receivables are paid then the firms investment into working capital is reduced as it converts these assets into cash

An increase in working capital is an investment and therefore implies a negative cash flow; decrease in working capital implies a positive cash flow . The cash flow is measured by the change in working capital , not the level of working capital


Further notes on depreciation

Modified accelerated cost recovery system (MACRS)- depreciation method that allows higher tax deductions in early years and lower deductions later (used by US firms )

The nominal amount of depreciation is fixed, and therefore the higher the rate of inflation the lower the real value of the depreciation that you can claim


Salvage value

When you sell equipment, you must pay taxes on the difference between the sales price and the book value of the asset

Book value equals initial cost - cumulative costs for depreciation
it is common to assume a salvage value of zero at the end of the assets depreciable life