English Guide

Net Present Value and Capital Budgeting

(Text reference: Chapter 7) Topics what to discount the CCA system total project cash flow vs. tax shield approach detailed CCA calculations and examples project interactions

AFM 271 - NPV and Capital Budgeting

Slide 1

What to Discount

some general principles: 1. Only cash flow is relevant the NPV rule is stated in terms of cash flows cash flow is a simple idea: dollars in - dollars out don’t confuse cash flow with accounting income (note that accounting income is needed in some cases to calculate taxes) 2. Always estimate cash flows on an incremental basis incremental cash flows are the additional cash flows generated by the project. To identify them, ask two questions: What is the cash flow if the project is taken? What is the cash flow if the project is not taken? If the answers differ, then the cash flow is incremental.

AFM 271 - NPV and Capital Budgeting Slide 2

Cont’d

some things to watch for: exclude sunk costs: it is incorrect to include costs which have already been incurred and cannot be recovered include opportunity costs: e.g. a firm owns some land worth $25 million which it is considering using as a new factory site. If the firm builds the factory, it is giving up the $25 million it could have received by selling the land. incorporate side effects: it is important to ensure that all effects on the remainder of a firm’s operations are taken into account (e.g. a new product line may reduce sales of existing products)

AFM 271 - NPV and Capital Budgeting Slide 3

Cont’d

include working capital requirements: most projects will require an additional investment in working capital (e.g. due to increased inventories, accounts receivable, etc.); such investments are typically recovered later on allocated overhead costs: ensure that only those charges which are actually due to a project are allocated to it interest expense: ignore this for now

AFM 271 - NPV and Capital Budgeting

Slide 4

Cont’d

3. Treat...