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Chapter 6: Making Investment Decisions with the NPV

ruleApplying the NPV rule

1. Only cash flow is important

• Always estimate cash flows on an after-tax basis

• Cash flows are recorded only when they occur, not when they are recorded2. Estimating Cash flows

• Do not confuse average with marginal payoffs: Perhaps an investment is saturatedand an increase investment yields a smaller payoff than an unsaturated investment(that has yielded less in the past).

• Include all Incidental Effects

• When forecasting cash flows for the PS4, you should include the decrease cashflow from decreased PS3 sales

• Recognise the importance of After-Sales Cash flows• Particularly important for manufacturing companies

• Do not Forget Working Capital requirements

• Net Working Capital = ST Assets - ST Liabilities

• Most projects entail an additional investment in working capital. This investmentshould, therefore, be recognised in your cash-flow forecasts

• Include Opportunity Costs

• If a project consists in using land that is owned by the company, the opportunitycost is the cash flow that could be generated by selling the land

• Sunk costs (irrecoverable) are irrelevant• Beware of Allocated Overhead Costs

• The principle of incremental cash flows says to include only the extra expensesthat would result from the project: we should be cautious about assuming that the

accountant’s allocation of overheads represents the true extra expenses thatwould be incurred (i.e. average values)

• Remember Salvage Value

• Salvage value (net of taxes) = Positive Cash flow at the end of the project• Shut-down cost = Negative cash flow at the end of the project

3. Treat inflation consistently• Use real cash flows with real discount rates

• Use nominal cash flows with nominal discount rates

• You will get the same results, either way

Investment Timing

• When cash flows are certain, the optimal timing is easy to determine• Examine alternative start dates (t) for the investment and calculate the net future

value at each of these dates. Then to find which of the alternatives would add most tothe firm’s current value, you must dicount these net future values back to the present:

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Equivalent Annual Cash Flows

• How much does it take to cover $X million investment?• Just take the length of the investment (t), the opportunity cost of capital and find the t-

year annuity payment with a PV equal to $X million:• PV of annuity = annuity payment x t-year annuity factor

• This annuity is an equivalent annual cash flow. It is the annual cash flow sufficient

to recover a capital investment, including the cost of capital for that investment, overthe investment’s economic life

• Two or more streams of cash outflows with different lengths or tie patterns can becompared by convertin their present values to equivalent annual cash flows, but inREAL TERMS

Further Notes

• Operating Cash Flows = Revenues - Cash expenses - taxes

• We analyse projects as if the were all-equity financed, treating all cash outflows ascoming from stockholders and all cash inflows as going to them. This apporach is usedin order to separate the analysis of investment decision from the finanncing decision,

• Depreciation: Depreciation offers tax shields• In order to increase expenses (and hence reduce taxes) companies often use

accelerated depreciaiton