EFB210 Lecture Notes - Lecture 6: Investopedia, Net Present Value, Cash Flow

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25 May 2018
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Week 6 Finance 1 Lecture Notes
Capital Budgeting 2
Marginal Analysis
Examines the additional/marginal/incremental cash flows that one project generates
relative to another
o A eaple ased o to iestets fo last eeks letue
o Can be used to evaluate the replacement of an asset, e.g. upgrading a facility
or replacing a piece of machinery:
From the marginal perspective, you ask:
What are the additional revenues and additional expenses?
Note that additional expenses may be negative expenses in
that they reduce expenses.
You also consider things such as the marginal effect on
depreciation.
The NPV of the marginal analysis indicates the additional NPV of one project relative
to another. In this example, Project B generates an additional $271.07 in NPV
relative to Project A when the discount rate is 10%.
The IRR of the marginal analysis indicates the point where both projects generate
the same NPV; 16.3% in this example.
When we evaluate the NPV of a project, this is a form of marginal analysis
o CFs of Company with
Project less CFs of
Company without Project
= CFs of Project
Project Yr 0 Yr 1 Yr 2 Yr 3 NPV IRR
A
-3,000
2,000 2,000 0 471.07 21.5
B
-6,200
4,000 4,000 0 742.15 18.8
B - A
-3,200
2,000 2,000 0 271.07 16.3
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Financial Model
Investopedia Definition
o The process by which a firm constructs a financial representation of
some, or all, aspects of the firm or given security. The model is usually
characterized by performing calculations, and makes recommendations
based on that information. The model may also summarize particular events
for the end user and provide direction regarding possible actions or
alternatives.
It asks the right questions
Its ased o eooi theo
Can simply report cash flows or report all financial statements
If constructed using a dynamic spreadsheet, it can analyse various scenarios, risks
and funding requirements
It is a useful management tool
But its ol as good as its iputs ad assuptios
Financial Model: Cash Flows
When modelling the cash flows of a project we need to carefully consider which cash
flows to include, their timing, the tax effect and the impact of inflation.
Generally, model incremental cash flows by
o Including incremental cash flows, opportunity costs and benefits
o Including the incremental tax effects, which are not always solely related to
cash flows, e.g. depreciation
o Excluding fiaig hages, eause thee osideed i the disout ate
ad e dot at to doule out
o Excluding suk osts eause thee ot ieetal
o Excluding allocated costs that are not incremental
o Being careful with the handling of inflation
o Taking a structured approach
Financial Mode: Structure
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Document Summary

Note that additional expenses may be negative expenses in that they reduce expenses: you also consider things such as the marginal effect on depreciation. 16. 3: the npv of the marginal analysis indicates the additional npv of one project relative to another. Investopedia definition: (cid:1688)the process by which a firm constructs a financial representation of some, or all, aspects of the firm or given security. The model is usually characterized by performing calculations, and makes recommendations based on that information. The model may also summarize particular events for the end user and provide direction regarding possible actions or alternatives. (cid:1689) It(cid:859)s (cid:271)ased o(cid:374) e(cid:272)o(cid:374)o(cid:373)i(cid:272) theo(cid:396)(cid:455: can simply report cash flows or report all financial statements. If constructed using a dynamic spreadsheet, it can analyse various scenarios, risks and funding requirements. It is a useful management tool: but it(cid:859)s o(cid:374)l(cid:455) as good as its i(cid:374)puts a(cid:374)d assu(cid:373)ptio(cid:374)s.

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