Chapter 7 - Chapter 7 Using the NPV Rule Incremental Cash...

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Chapter 7 Using the NPV Rule

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Incremental Cash Flows Always use cash flows rather than accounting figures in NPV calculations Always use incremental cash flows. What does this mean? Calculate cash flows as: cash flows with project less cash flows without project (1) Sunk costs should be ignored in calculating incremental flows Example : if you have already paid for a marketing study, the cost already paid (i.e,. sunk) should have no bearing on your calculations or decisions
(2) Opportunity costs should be included in calculating incremental flows If already own an asset that will be used for project, must subtract the maximum PV of cash flows that asset could fetch under alternative use Example : if you own a piece of land that you will use to build a factory, the value of that land must be treated as a cost (3) All negative or positive side effects should be included in incremental flows Example : producing new economy car will generate more profitable future sales as customers become attached to your brand – positive side effect Example : developing new jumbo jet line will erode some sales of existing lines – negative side effect

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Inflation Example Suppose you can earn 10% annual interest depositing \$1000 cash in bank Expected inflation is 5% Hamburgers cost \$1.00 today Today you could purchase 1,000 hamburgers Next year you should have \$1,100 in cash. Hamburgers will cost \$1.05. You can purchase 1,100/1.05 = 1047.62 hamburgers. The real interest rate in terms of what one can buy is (1,047.62-1,000)/1,000 = 4.762%.
Mathematical Relationships (1 + Nominal interest rate) = (1 + Real interest rate) x (1 + Inflation rate) Real interest rate = [(1 + Nominal interest rate)/(1+Inflation rate)] – 1 Often we make the approximation: Real interest rate Nominal interest rate – Inflation rate In example above: Real interest rate = [1.10/1.05] – 1 = 4.762% Real interest rate 10% - 5% = 5%

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How does inflation affect present value calculations? General rule Discount nominal cash flows at the nominal discount rate Discount real cash flows at the real discount rate Example Nominal discount rate = 15%, Inflation is expected to be 10% Real discount rate = (1.15/1.10) –1 = 4.5% Projected real cash flows Projected nominal cash flows C 0 -100 -100 C 1 +35 35 x 1.10 = +38.5 C 2 +50 50 x (1.10) 2 = +60.5 C 3 +30 30 x (1.10) 3 = +39.9
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This note was uploaded on 10/17/2011 for the course ECON 101 taught by Professor Thompson during the Spring '11 term at Michigan State University.

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Chapter 7 - Chapter 7 Using the NPV Rule Incremental Cash...

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