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Chapter 9

Chapter 9 ECON 2560

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ECON 2560
Tahsin Mehdi

Chapter 9 ECON 2560 Using Discounted Cash Flow Analysis to Make Investment Decisions IDENTIFYING CASH FLOWS  To calculate NPV, you need to discount cash flows not accounting profits  THERE IS A DIFFERENCE BETWEEN CASH FLOW AND PROFITS  Income statements are intended to show how well the firm has performed but DON’T track cash flows  Accountants don’t deduct capital expenditure when calculating the year’s income but instead depreciates it over time Discount Incremental Cash Flows  A project’s present value depenst on the extra cash flows that it produces  Forecast the firm’s cash flows 1 if you proceed w/ the project then forecast the cash flows if you don’t accept the project  The difference = the cash flows produced by the project (incremental cash flow) Incremental Cash Flow = Cash flow with project – Cash flow without project Include All Indirect Effects  Be aware that new products often damage sales of an existing product  Sometimes the opposite occurs and a new project will help the firm’s existing business Forget Sunk Costs  Sunk costs are post and irreversible outflows and shouldn’t be used to make decision  Unfortunately managers are often influenced by sunk costs  “ Waste to quit a project we’ve already put X amount of money in”  common manager thought Include Opportunity Costs  Resources are almost never free even when no cash changes hands (e.g. New manufacturing operation uses land that could otherwise be sold for $$) Opportunity Cost: Benefit or cash flow foregone as a result of an action  Compare the cash flows with & without the project not before and after project Recognizing the Investment in Working Capital Net working capital = Current assets – Current liabilities  The main short-term assets are cash, accounts receivable (customer’s unpaid bills), & inventories of raw materials & finished goods  The main short-term liabilities are accounts payable (bills have yet to pay), notes payable & accruals (liabilities for items such as wages or taxes that have recently been incurred but not paid) Most common mistakes w/ working capital… 1. Forgetting about working capital entirely 2. Forgetting that working capital my change during the life of the project 3. Forgetting that working capital is recovered at the end of the project : When project is over, inventories are run down, any unpaid bills are paid off and you can recover your investment in working capital (generates cash inflow) Remember Shutdown Cash Flows  The end f a project almost always brings additional cash flows (usually negative but not always)  Might need/want to sell plant, equipment, real estate etc. at end of project Beware of Allocated Overhead Costs  Overhead costs may not be related to the particular project but must nevertheless be paid for  When the accountant assigns costs to the firm’s project’s a charge for overhead is usually made  Our principle of incremental cash flows says that in investment appraisal we should include only the extra expenses that would result from the project Discount Nominal Cash Flows by the Nominal Cost of Capital  Interest rates are usually quoted in nominal terms  The real rate of interest on the bank deposit depends on inflation  If the discount rate us nominal, consistency requires the cash flows be estimated in nominal terms as well, taking into account trends in the selling price, labour, materials costs etc. Separate Investment & Financing Decisions  When we calculate the cash flows from a project, we ignore how that project is financed  Regardless of how its financed, we should view the project as coming from shareholders and all cash inflows as going to them  This procedure focuses exclusively on the project cash flow, not the cash flows associated w/ alternative financing schemes  Therefore allows you to separate the analysis of the investment decision from that of the financing decision CALCULATING CASH FLOWS Total Cash Flow = cash flow from investment in plant & equipment + cash flows from investment in working capital + cash flow from operations Capital Investment  To get a project off the ground, a company will typically need to make considerable up-from investments in plant, equipment, research, marketing etc.  May have negative cash flow at end of project if there are lots of shutdown costs or could be positive if there is salvage value Operating Cash Flow Operating cash flow = revenues – costs – taxes  Many investments don’t result in additional revenues; they are simply designed to reduce the costs of the company’s existing operations  Such projects also contribute to the operating cash flow of the firm  not by incre
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