Net Present Value and Cash Flows Essay

Week 2 notes

-company is trying to figure out if they should make an investment decision
-investments cost money, so no wasting shareholders money

TECHNIQUES
-Payback period shorter the better (whats too long? ) once its paid back you stop, it ignores all cash flows beyond the payback period. Doesn’t take into the time value of money.
-Discounted payback- you converted the nominal cash flows in each time period into their equivalent present value, you need the appropriate discount rate. Always LONGER. Shorter investments are better, but you need a benchmark to compare it too.
-Accounting rate of return- uses net profit or net income from the income statement, doesn’t use cash flows like the other two above. Not an omtimal capita budgeting technique.
-net present value- not the most popular but considered the best technique to make a decision. Cacluate the future cashflows less the …. 0 or above you accept, below you reject. If the project is cost only, you get a negative NPV, so you just pick the least negative NPV. Higher cashflows increase NPV. If cost of capital inc, it has a negative impact on the NPV. Size effect- big profitable numbers have big Npvs, vice versa. NPV tells you how much the stockholders wealth will change
-profitabilty index- original investment cost +NPV divided by original investment cost, zero NPV would equal 1, so you need this number to be greater than 1. NPV is better then this.
-internal rate of return- most popular, where the NPV equals 0 , what rate of return makes NPV = 0
-Modified internal rate of return- most popular

Decision
ACEEPT OF REJECT THE DECISION

Estimating cash flows

a.Revenue generating- never being paid back is not good here.
b. cost only- government can shut you down, youre not expecting make a profit..just minimize your cost

TIME 0 1 2 3 4 5
CASH FLOW -5 +2 +1 +3 -1 +2 you cant use IRR here short coming of IRR
-reinvesting yr 1 to 5 cash flows

revenue gen: high risk high discount risk

COST ONLY high risk low discount rate
NPV RISK DISCOUNT RATES: 9 and 11 %
A-6 HI
B-8 HI
C-12 LOW

estimating cash flows

initial investment t=0
Purchase price of asset instal costs freight + or - sale of old asset
+ or - tax implication from sale of the old asset (below how it works)
+working capital investment
__________________________________
net income

Book value of asset $200 a loss if you sell for 150 a gain if you sell for more then 200 * how your gains are taxed (gain x tax rate) * if you have a loss you have a tax refund ( loss X tax rate) if you lose, you don’t have to pay taxes

Book Value= original cost- accumulated depreciation
Tax Depreciation Canada (CCRA) US (MACRS)

tax dep= % depreciation rate for

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