Lecture_5_-_The_Time_Value_of_Money_-_Making_Investment_Decisions

Lecture_5_-_The_Time_Value_of_Money_-_Making_Investment_Decisions

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Money Markets and Finance Lecture 5 The Time Value of Money: Making Investment Decisions 1. Lecture Overview In this lecture, we will discuss how to use the time value of money concepts introduced in Lecture 2 to identify the projects a firm should undertake. It is important to be able to do this as firms only have limited resources and therefore only want to take on the best available projects. We call this evaluation process capital budgeting . 1. Lecture Overview In introducing the concept of capital budgeting, we will discuss: Which cash flows should be taken into consideration when deciding whether to undertake a project; The use of the net present value rule in project evaluation; and, How the net present value rule can be used to choose between mutually exclusive projects and projects with different lives. 2. Identification of Relevant Cash Flows When considering an investment project, it is important to note we are only concerned with the incremental cash flows associated with the project. The incremental net cash flow of a project is defined as the difference between the firm’s cash flows if the project is undertaken and the firm’s cash flows if the project is not undertaken. 2. Identification of Relevant Cash Flows Example: Incremental Cash Flows Imagine Arnotts Biscuits is considering introducing the white chocolate Tim Tam biscuit. The new biscuit is expected to generate net cash flows of $10 million. However, it is also expected that a number of consumers of current types of Tim Tams will switch to the new type. If $1 million of the $10 million net cash flows described above comes from existing customers, the incremental cash flow from the new biscuit is $9 million. It is the $9 million that is of concern in evaluating whether the new biscuit should be launched. 2. Identification of Relevant Cash Flows What are cash flows? Cash flows are money physically paid or received by the firm. The firm’s net cash flow in period t, X t , is defined as the difference between its cash inflows and cash outflows, or: Where: R t = Cash revenues generated by the firm in period t; E t = Cash revenues paid by the firm in period t (NB: Does NOT include depreciation); I t = Capital expenditure paid in period t; and, T t = Income taxes paid in period t. tt t tttt X CashInflows CashOutflows REIT = =−−−
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2. Identification of Relevant Cash Flows How is income tax calculated? Income tax paid, T t , is calculated as follows: Where: τ = The corporate tax rate; and, D t = Depreciation charge for period t. Note that depreciation is not included as a cash expense in E t . This is because it is not a cash flow.
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Lecture_5_-_The_Time_Value_of_Money_-_Making_Investment_Decisions

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