Sound Investment Decisions Should Be Based On The Net Present Value (NPV) Rule. Problems To Be Resolved in Applying The NPV Rule

INTRODUCTION
Sound
investment decisions should be based on the

net present value (NPV) rule.
Problems
to be resolved in applying the NPV rule
What should be discounted? In theory, the answer is:

We should always discount cash flows.
What rate should be used to discount cash flows? In
principle, the opportunity cost of capital should be
used as the discount rate.
CASH FLOWS VERSUS

PROFIT
Cash flow is not the same thing as profit, at least, for

two reasons.
First, profit, as measured by an accountant, is based on accrual

concept.
Second, for computing profit, expenditures are arbitrarily divided

into revenue and capital expenditures.
CF (REV EXP DEP) DEP CAPEX
CF Profit DEP CAPEX
INCREMENTAL CASH
FLOWS
Every investment involves a comparison of alternatives:
When the incremental cash flows for an investment are

calculated by comparing with a hypothetical zero-cash-flow
project, we call them absolute cash flows.
The incremental cash flows found out by comparison
between two real alternatives can be called relative cash
flows.
The principle of incremental cash flows assumes greater

importance in the case of replacement decisions.
Example
4
Suppose a firm is considering replacing an equipment at book

value of Rs. 5000 and market value of Rs. 3000. New
equipment will require an initial cash outlay of Rs 10,000, and
is estimated to generate cash flows of Rs 8,000, Rs 7,000 and
Rs 4,500 for the next 3 years.
The book value of old machine is a sunk cost. Market value is
opportunity cost.
Thus, on an incremental basis the net cash outflow of new
equipment is: Rs 10,000 Rs 3,000 = Rs 7,000.
Also, The differences of the cash flows of new equipment over
the cash flows of old equipment are incremental cash flows.
COMPONENTS OF CASH
FLOWS
Initial Investment
Net Cash Flows
Depreciation and Taxes

Net Working Capital
Change in accounts receivable

Change in inventory
Change in accounts payable
Free Cash Flows
Terminal Cash Flows
Salvage Value
Salvage value of the new asset

Salvage value of the existing asset now
Salvage value of the existing asset at the end of its normal
Tax effect of salvage value
Release of Net Working Capital
Initial Investment
Initial
investment is the net cash outlay in the period

in which an asset is purchased.
A major element of the initial investment is gross
outlay or original value (OV) of the asset, which
comprises of its cost (including accessories and spare
parts) and freight and installation charges.
Original value is included in the existing block of
assets for computing annual depreciation.
Example of Initial
Investment
Wattle Extract Project: Initial

Investment
Net Cash Flows

8
Consist of annual cash flows occurring from the operation of

an investment, but it is also be affected by changes in net
working capital and capital expenditures during the life of the
investment.
Net cash flow = Revenues - Expenses - Taxes
NCF = REV - EXP - TAX
The computation of the after-tax cash flows requires a careful

treatment of non-cash expense items such as depreciation.
Depreciation, calculated as per the income tax rules influences
cash flows indirectly by way of depreciation tax shield.
Calculation of Depreciation
For Tax Purposes
Two most popular methods of charging depreciation are:

straight-line
Diminishing balance or written-down value (WDV)
methods.
For reporting to the shareholders, companies in India could
charge depreciation either on the straight-line or the writtendown value basis.
No choice of depreciation method and rates for the tax
purposes is available to companies in India.
Depreciation is computed on the written down value of the
block of assets and rates are specified.
10
Net Working Capital

It
is the difference between change in current assets

(e.g., receivable and inventory) and change in
current liabilities (e.g., accounts payable) to profit.
Increase in net working capital should be
subtracted from and decrease added to after-tax
operating profit.
NCF = EBIT (1 - T ) + DEP - NWC
Free Cash Flows

11
It
is the cash flow available to service both lenders

and shareholders, who have provided, respectively,
debt and equity, funds to finance the firms
investments.
It is this cash flow, which should be discounted to
find out an investments NPV.
12
Terminal Cash Flow:

Salvage Value
Salvage
value is a terminal cash flow.

Salvage value may be defined as the market price
of an investment at the time of its sale.
No immediate tax liability (or tax savings) arises on
the sale of an asset because the value of the asset
sold is adjusted in the depreciable base of assets.
Effects of Salvage Value

13
Salvage value of the new asset: It will increase cash inflow

in the terminal (last) period of the new investment.
Salvage value of the existing asset now: It will reduce the

initial cash outlay of the new asset.
Salvage value of the existing asset at the end of its normal

life: It will reduce the cash flow of the new investment of in
the period in which the existing asset is sold.
14
Release of Net Working

Capital
Besides
salvage value, terminal cost flows will also

include the release of net working capital.
It is reasonable to assume that funds initially tied
up in net working capital at the time the investment
was undertaken would be released in the last year
when the investment is terminated.
15
CALCULATION OF
DEPRECIATION FOR
Two most popular methods of charging depreciation are:
TAX
PURPOSES
Straight-line and diminishing balance
1.
2.
Written-down value (WDV) methods
In India, depreciation is allowed as deduction every year on the

written-down value basis in respect of fixed assets as per the
rates prescribed in the Income Tax rules.
Depreciation is computed on the written down value of the block
of assets.
Depreciation base
16
In the case of block of assets, the written down value is

calculated as follows:
The aggregate of the written down value of all assets in the
block at the beginning of the year
Plus the actual cost of any asset in the block acquired during
the year
Minus the proceeds from the sale of any asset in the block
during the year
Thus, in a replacement decision, the depreciation base of a new
asset will be equal to: Cost of new equipment + Written down
value of old equipment Salvage value of old equipment
17
Cash Flow Estimates for

New Products
It
depends on forecasts of sales and operating

expenses.
Sales forecasts require information on the quantity
of sales and the price of the product.
Anticipation of the competitors reactions.
18
Salvage Value and Tax

Effects
As
per the current tax rules in India, the after-tax

salvage value should be calculated as follows:
Book value > Salvage value:
After-tax salvage value = Salvage value + PV of

depreciation tax shield on (BV SV)
Salvage value > Book value:
After-tax salvage value = Salvage value - PV of depreciation

tax shield lost on (SV BV)
19
Terminal Value for a New

Business
The terminal value included the salvage value of the asset and
the release of the working capital.
Managers make assumption of horizon period because detailed

calculations for a long period become quite intricate. The
financial analysis of such projects should incorporate an
estimate of the value of cash flows after the horizon period
without involving detailed calculations.
A simple method of estimating the terminal value at the end of

the horizon period is to employ the following formula, which is
a variation of the dividend growth model
NCFn 1 g NCFn 1
TVn
kg
kg
20
Terminal Value of New

Business / New Products
New businesses have the potential of generating revenues and

cash flows much beyond the assumed period of analysis,
which is referred to as horizon period.
A simple method of estimating the terminal value at the end of
the horizon period is:
TVn =
NCFn ( 1 + g )
k- g
NCFn+1
k- g
where NCFn+1 is the projects net cash flow one year after the
horizon period, k is the opportunity cost of capital (discount rate)
and g is the expected growth in the projects net cash flows.
21
Cash Flow Estimates for

Replacement Decisions
The
initial investment of the new machine will be

reduced by the cash proceeds from the sale of the
existing machine.
The annual cash flows are found on incremental
basis.
The incremental cash proceeds from salvage value
is considered.
22
Additional Aspects of
Incremental Cash Flow
Allocated Overheads
Analysis
Opportunity Costs of Resources

Incidental Effects
Contingent costs
Cannibalisation
Revenue enhancement
Sunk Costs
Tax Incentives
Investment allowance Until
Investment deposit scheme
Other tax incentives
23
Investment Decisions
Under Inflation
Executives generally estimate cash flows assuming unit costs and

selling price prevailing in year zero to remain unchanged. They argue
that if there is inflation, prices can be increased to cover increasing
costs; therefore, the impact on the projects profitability would be the
same if they assume rate of inflation to be zero.
This line of argument, although seems to be convincing, is fallacious

for two reasons.
First, the discount rate used for discounting cash flows is generally
expressed in nominal terms. It would be inappropriate and inconsistent to
use a nominal rate to discount constant cash flows.
Second, selling prices and costs show different degrees of responsiveness
to inflation
The depreciation tax shield remains unaffected by inflation since
depreciation is allowed on the book value of an asset, irrespective of its
replacement or market price, for tax purposes.
Nominal VS. Real Rates of

Return
24
For a correct analysis, two alternatives are available:
either the cash flows should be converted into nominal terms and then
discounted at the nominal required rate of return, or
the discount rate should be converted into real terms and used to discount the
real cash flows
Important: Discount nominal cash flows at nominal discount rate; or

discount real cash flows at real discount rate.
Example: If a firm expects a 10 per cent real rate of return from an

investment project under consideration and the expected inflation rate is 7
per cent, the nominal required rate of return on the project would be:
k = (1.10)(1.07) - 1 =1.177 - 1 = 0.177 or 17.7%
25
It would be inconsistent to discount the real cash flows of the project

by the nominal discount rate. For example, in case of following cash
flows discounting with 14% nominal rate of real cash flows returns
negative NPV:
The cash flows should be discounted with real discount rate as

follows:
1.14
K=
- 1 = 0.0654
1.07
26
Financing effects in
Investment Evaluation
According to the conventional capital budgeting approach

cash flows should not be adjusted for the financing effects.
The adjustment for the financing effect is made in the

discount rate. The firms weighted average cost of capital
(WACC) is used as the discount rate.
It is important to note that this approach of adjusting for the

finance effect is based on the assumptions that:
The investment project has the same risk as the firm.

The investment project does not cause any change in the firms target
capital structure.

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INTRODUCTION

investment decisions should be based on the

to be resolved in applying the NPV rule

What should be discounted? In theory, the answer is:

CASH FLOWS VERSUS

Cash flow is not the same thing as profit, at least, for

First, profit, as measured by an accountant, is based on accrual

Second, for computing profit, expenditures are arbitrarily divided

Every investment involves a comparison of alternatives:

When the incremental cash flows for an investment are

The principle of incremental cash flows assumes greater

Suppose a firm is considering replacing an equipment at book

Depreciation and Taxes

Change in accounts receivable

Free Cash Flows

Terminal Cash Flows

Salvage value of the new asset

Release of Net Working Capital

investment is the net cash outlay in the period

Wattle Extract Project: Initial

Net Cash Flows

Consist of annual cash flows occurring from the operation of

The computation of the after-tax cash flows requires a careful

Two most popular methods of charging depreciation are:

Net Working Capital

is the difference between change in current assets

Free Cash Flows

is the cash flow available to service both lenders

Terminal Cash Flow:

value is a terminal cash flow.

Effects of Salvage Value

Salvage value of the new asset: It will increase cash inflow

Salvage value of the existing asset now: It will reduce the

Salvage value of the existing asset at the end of its normal

Release of Net Working

salvage value, terminal cost flows will also

Written-down value (WDV) methods

In India, depreciation is allowed as deduction every year on the

In the case of block of assets, the written down value is

Cash Flow Estimates for

depends on forecasts of sales and operating

Salvage Value and Tax

per the current tax rules in India, the after-tax

Book value > Salvage value:

After-tax salvage value = Salvage value + PV of

Salvage value > Book value:

After-tax salvage value = Salvage value - PV of depreciation

Terminal Value for a New

Managers make assumption of horizon period because detailed

A simple method of estimating the terminal value at the end of

Terminal Value of New

New businesses have the potential of generating revenues and

Cash Flow Estimates for

initial investment of the new machine will be

Opportunity Costs of Resources

Executives generally estimate cash flows assuming unit costs and

This line of argument, although seems to be convincing, is fallacious

Nominal VS. Real Rates of