Lecture 4 - UGBA 103 Lecture Slides Set 4 Using NPV Rule...

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UGBA 103 Lecture Slides – Set 4 Using NPV Rule for Capital Budgeting Decisions
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Topics Covered In this note: Financial Cash Flows and Accounting Profits Treatment of Inflation Depreciation Equivalent Annual Costs
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Cash Flows and Accounting Cash flow is money realized at a particular point in time, while Profit is money earned during a given period The difference between the two will be accounted for in part by WC , the changes in net working capital The other major difference between the two is on account of depreciation
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Cash Flows and Accounting Profits (2) Much of the work in evaluating a project lies in starting with projected financial statements, such as balance sheet and income statement, and then taking the accounting numbers contained therein and computing projected cash flows
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Incremental Cash Flows Sunk costs are not relevant Just because “we have come this far” does not mean that we should continue to throw good money after bad. Opportunity costs do matter. A positive NPV project adds to the firm value, but has to be evaluated against alternative opportunities.
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Incremental Cash Flows (2) Side effects matter If our new product causes existing customers to demand less of current products, we need to recognize that On the other hand, if synergies result that create increased demand of existing products, we also need to recognize that (Gillette Razors + Duracell example)
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What To Discount Only Incremental Cash Flows matter Include all incidental effects Account for WC Include opportunity costs Forget sunk costs Include only extra overheads incurred on account of the project Treat inflation consistently Points to “Watch Out For”
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Be consistent in how you handle inflation! Use nominal interest rates to discount nominal cash flows. Use real interest rates to discount real cash flows. You will get the same results, whether you use nominal or real figures Inflation INFLATION RULE INFLATION RULE
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Suppose you earn a nominal return of r N on each dollar that you save per period. Then each dollar of foregone consumption at t =0 will lead to your having an additional $(1+ r N ) at t =1 Suppose the inflation rate over the period between t =0 and t =1 is i . This means that in order to buy what $1 bought at t =0, you will need to spend $(1+ i ) at t =1 Nominal and Inflation Rates
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Between t =0 and t =1 your wealth increased from $1 to $(1+ r N ). However, each dollar at t =1 buys less than what it did at t =0. We want to find out what has been the increase in your purchasing power taking both nominal return and inflation into consideration Let us denote by r the return we would have earned if there were no inflation. In other words, r is the increase between t =0 and t=1 per dollar of purchasing power at t=0 Nominal, Real, and Inflation Rates
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We started with the assumption that you saved $1 at t =0. Thus, at t =0, your
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Lecture 4 - UGBA 103 Lecture Slides Set 4 Using NPV Rule...

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