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Who estimate?
Capital outlays-----engineering and product outlay dept. Revenue projectionmarketing group Operating cost----- production dept. cost accountants, purchase manager, personnel exe, tax expert Finance manager coordinate the efforts Minimizes the biases inherent in cash flow forecasting
Basic principles
Separation Principle Incremental Principle Post tax Principle Consistency Priciple
Separation Principle
Profit after tax + interest(1- tax rate)
Incremental Principle
Guidelines: Consider all incidental effects Ignore sunk cost Include opportunity cost Question of allocation of overhead cost Estimate working capital properly
Include project-driven changes in working capital net of spontaneous changes in current liabilities
Consistency Principle
Cash flows and discount rate must be consistent with respect to inflation Cash flow Nominal Cash flow Real Cash flow discount rate nominal discount rate real discount rate
Understatement of profitability
Salvage values are under estimated Intangible benefits are ignored
b) c) d) e) f) g)
d) e)
+ =
5,000 Rs.37,075
a) Represent the depreciation on the new project. b) Represent the remaining depreciation on the old project. c) Net change in tax depreciation charges.
d) e)
+ =
5,000 Rs.19,075
Asset Replacement
Year 0 -Rs.66,600 Year 1 Rs.12,933 Year 2 Rs.16,046 Year 3 Year 4 Rs.10,147 Rs.19,075
Recapitulation
Basic characteristics of relevant project flows
Cash (non accounting flows) Operating ( non financing Flows) After tax flows Incremental flows
Example Given the following costs of operating two machines and a 6% cost of capital, select the lower cost machine using equivalent annual cost method.
Year 1 15 10
Machine A B
2 5 6
3 5 6
4 5
Timing
Even projects with positive NPV may be more valuable if deferred. The actual NPV is then the current value of some future value of the deferred project.
Net future value as of date t Current NPV ! t (1 r )
Timing
Example You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV? Harvest Year
0 % change in value 1 28.8 2 77.5 20.3 3 89.4 4 5 9.4 Net FV (Rs.1000s) 50 64.4 100 109.4
15.4 11.9
Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV? 64.4
1.10
! 58.5
Timing
Example - continued
You may harvest a set of trees at anytime over the next 5 years. Given the FV of delaying the harvest, which harvest date maximizes current NPV?
Annual output per machine Operating cost per machine PV operating cost per pachine
Recapitulation
Basic principles that must be adhered to in estimating after tax incremental cash flows
Ignore sunk cost Include opportunity cost Include project driven changes in NWC Includes effects of Inflation