LECTURE7

# LECTURE7 - Lecture 7 Lecture NPV and Capital Budgeting Cash...

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Lecture 7 Lecture 7 NPV and Capital Budgeting NPV and Capital Budgeting

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Cash flows calculations NPV analysis is based on cash flows not accounting earnings . Capital investments are treated as current expenses in cash flow analysis, but are depreciated in earnings calculation. Depreciation nevertheless affect taxes , and thus cash flows & NPV . Changes in net working capital represent cash flows . Changes in inventories of raw materials and goods in process Changes in accounts receivable and accounts payable Changes in cash on hand needed for unexpected expenses Only cash flows incremental to a project should be used. Sunk costs are irrelevant to the NPV of going ahead. Lost opportunities to sell assets affect NPV of a project. Erosion of sales from existing product lines also affect NPV .
Income needs to be calculated to calculate tax payments . Example Example : : Baldwin company Investment in net working capital represents cash outflow Cash flows calculations (continued)

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Inflation and Capital budgeting The real interest rate r r is defined by inflation of rate the is rate interest nominal is where , 1 1 1 π n n r r r r + + = + If the rate of inflation is , a project with real cash flow has nominal cash flow ( 29 3 2 1 0 , , , C C C C - ( 29 ( 29 ( 29 ( 29 3 3 2 2 1 0 1 , 1 , 1 , + + + - C C C C ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 3 3 2 2 1 0 3 3 3 2 2 2 1 0 1 1 1 1 1 1 1 1 1 1 1 1 r r r n n n r C r C r C C r C r C r C C NPV + + + + + + - = + + + + + + + + + - =
Inflation and Capital budgeting (continued) More convenient to use nominal cash flows for the depreciation tax deduction Depreciation allowances are based on historical costs ( nominal! ) On the other hand, anticipated sales revenues are often based on forecasts of sales (number of units) and relative prices ( 29 ( 29 ( 29 n inflation n date at price nominal prices relative = Nominal cash flows discounted with nominal interest rate gives the same NPV as real cash flows discounted with real interest rate .

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Example Example ( 29 000 10 sales unit forecasted of number years, 4 in , = ( 29 6 . 13 price nominal forecasted = ( 29 % 6 rate inflation expected = ( 29 million , 08 . 1 06 . 1 6 . 13 000 10 revenue sales d anticipate of power purchasing 4 = × = real cash flow at date 4, since it is expressed in terms of date 0 purchasing power
Example Example : : Baldwin Company Baldwin Company Item Value Expected life of bowling ball machine 5 years Cost of test marketing (sunk cost already spent!) \$250,000 Current market value of proposed factory site \$150,000 Cost of bowling ball machine \$100,000 Estimated market value of machine after 5 years \$30,000 Production (in thousands of units) over 5 years 5, 8, 12, 10, 6 Net working capital at end of years 0~5 (in \$'000) 10, 10, 16.32, 24.97, 21.22, 0 Pirce first year (and assumed growth) \$20 (2% growh) Production cost first year (and assumed growh) \$10 (10% growth) Annual inflation rate 5% Table 1: The Initial Facts

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LECTURE7 - Lecture 7 Lecture NPV and Capital Budgeting Cash...

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