448_07ApplyingNPV - Lecture Notes 7 Net Present Value and...

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54 Lecture Notes 7 Net Present Value and Capital Budgeting Calculating incremental cash flows • The most important point to consider is that net present value analysis is based on cash flows not accounting earnings . A major difference between cash flows and earnings is the treatment of cap- ital. For the purpose of calculating earnings, new capital investments are depreciated . In cash flow analysis investments are treated like current expenses – they are subtracted immediately they are made and the revenue from the sale of capital at the end of the project is included as a positive cash flow. Depreciation is not irrelevant to net present value analysis, however, since de- preciation deductions that reduce taxes do affect the real cash flows from an investment. • Another key issue to consider when applying net present value analysis is that it is the cash flows that are incremental to a project that should be used. In particular, this means that sunk costs that have already been incurred in pilot projects, marketing studies and the like are irrelevant to cal- culating the NPV of going ahead with the project. On the other hand, there may be other costs that appear as a loss in cash flows elsewhere in the business rather than additional cash expenditures from new revenue. These opportunity costs are part of the cash flows caused by going ahead with the investment and therefore should be counted as costs of the project. For example, the new in- vestment could use an old warehouse. Without the new investment, the warehouse could have been sold or leased. The loss in lease income or capital from the sale of the warehouse therefore needs to be counted as a cost of the new investment project. As another example, if the project involves producing and marketing a new product line, there may be an erosion of sales from ex- isting product lines. This loss in revenue from sales of existing products needs to be counted as a negative cash flow associated with the new project. • Another key issue to keep in mind when analyzing cash flows is that additional production gen- erally will require i. higher inventories of raw materials, goods in process and finished goods; ii. may also lead to the accumulation of accounts receivable and accounts payable
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55 iii. may require additional cash on hand to finance additional unexpected expenditures. These changes in working capital represent a cash outflow because they tie up cash generated elsewhere in the firm. In declining years of the project, inventories are eliminated, accounts re- ceivable are collected, and accounts payable are cleared. The changes in working capital there- fore are likely to be positive. The word changes has been italicized, since many students make the mistake of using the level of working capital to calculate cash flows.
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This note was uploaded on 12/20/2011 for the course ECON 448 taught by Professor Bejan during the Spring '06 term at Rice.

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448_07ApplyingNPV - Lecture Notes 7 Net Present Value and...

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