CFTP WK1 Notes

University of Technology Sydney **We aren't endorsed by this school
Oct 18, 2023
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WEEK ONE: Estimating Cash Flows and NPVs ARTICLE How to Use Net Present Value Analysis - Anet present value analysis assesses a project that requires a cash outlet upfront to achieve lower costs going forward - Avyear from now, a dollar will not be worth as much as a dollar today; there is a cost associated with having your cash tied up for a year - Cost of capital - you have to borrow money and pay interest, or you may have to forego other projects that would've had a positive return - Suppose, your cost of capital is 15%. A dollar today will be $1.15 a year from now - To complete the analysis, we discount all the positive cash flows we expect to happen in the future to put them in today's dollars, so the client can compare the positive cash flows to the negative. - A good analysis alone rarely provides the answer to a business problem. Rather, it allows you to identify the critical factors to which the decision is sensitive. Related: Consider These 5 Factors Before Making Your Next Big Decision ¢ Production volume -- There is an assumption about the volume the new technology will be required to produce that will be determined by your sales. How much lower would sales have to be to cause this to be a bad investment (i.e., cause the NPV to be negative)? e Cost savings The analysis assumes that your costs will be reduced, but suppose you don't realize all of these savings? How much lower would annual savings have to be to cause the NPV to become negative? e Price -- There will be an assumption about how much you will get for your product. What happens if the price changes? Is this likely? e Time horizon -- The analysis will have an end date (perhaps 10 years from now). If new technology could come along in five years that will make your purchase obsolete, a 10-year time horizon is too long. e Terminal value -- How much is the technology assumed to be worth at the end of the time horizon? Perhaps you could sell it, but it may be worth no more than scrap value. In fact, you may have to pay to have it removed. ¢ Discount rate -- Does the discount rate used in the analysis reflect your true cost of capital? - For example, the sensitivity analysis may show that if unit sales grow at 10% per year or more, the investment is a good one. If sales grow less than that, the new technology isn't a good investment. You can then apply your judgment to determine how much you think sales will grow.
VIDEO 1 How to Calculate a Project's NPV?¢ - Time value of money: a dollar received today is more valuable than a dollar received tomorrow (today's money can be reinvested, thus vielding a greater value in the future) - NPV: determining the value of an investment - The opportunity cost of capital is the alternative return investors forego when they undertake investment. VIDEO 11 How Does Discounted Cash Flow Impact Your Small Business? - Why use discounted cash flow? - Helps determine your return on investment by buying specific equipment - In other words, what's it going to cost you to purchase it over a period of time and what will it be doing for you over that period of time? - 3 key factors: cost of equipment over time, interest rate and revenue LECTURE ONE Estimate cash flows on an incremental basis. The value of a project depends on all the incremental cash flows after-tax that follow from projecl acceptance. Cash flows are different to accounting profits which include income and expenses not yet received/paid as well as depreciation charges which are not cash flows at all. Important to include all incidental effects on the remainder of the firm's business such as existing products sales. Recognise after-sales cash flows to come later such as downstream activities on service and spare parts. Working Capital Requirements Firms generally use sales and COGS to estimate cash flow: Cash inflow = Sales Cash outflow = COGS Net cash flow = cash inflow - cash outflow = [Sales - COGS] These are then amended to include changes in working capital. i.e. any changes in Current Assets and Current Liabilities.
A positive amount of [A/C Receivable + Inventory - A/C Payable] is an additional investment in the net-working capital and is treated as an outflow. All the investments in working capital over the life of the project are recovered (as cash inflow) at the end of the project's life. Include Opportunity Costs The opportunity cost of a resource used in a project should be included even when no cash changes hands. E.g. A new operation will use an already acquired land that could otherwise be sold. The new opportunity cost of the land is the cash it could generate for the company if the project were rejected and the land was sold or put to some other productive use. Should judge projects on the basis of "with or without". Sunk Costs, Allocated Overhead Costs, Inflation and Salvage Value - Ignore past and irreversible sunk costs - Ignore the accountant's allocation of existing overheads and include only the extra overhead expenses generated bu a project Remember the salvage value (net of any taxes) when the project comes to an end. Treat inflation consistently by discounting nominal cash flows at a nominal rate of return and real cash flows at a real rate. Separate Investment and Financing Decisions Analyse the project as if it were all equity-financed. If a property is partly financed by debt, we will neither subtract the debt proceeds from the required investment nor recognise interest and principal payments on the debt as cash outflows. Financing costs are recognised in the discount rate instead. Depreciation Depreciation is an allowable tax deduction against profit. It provides an annual tax shield: Tax shield = (depreciation * tax rate) The tax shield is implicitly shown in the reduced amount of tax on operations recorded in the income statement. As depreciation is a non-cash expense, it has to be added back to profit after-tax to arrive at the net cash flow.
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