Capital investment:regardless of whether they involve a tangible or intangiable asset. The incestment creates wealth if the discounted value of the future cash flow exceeds the up front cost. The problem is what to discount- stick to these rules: 1. Only cash flow is relevant. Net present value depends on future cash flows it’s the difference between cash received and cash paid out. Cash should be recorded only when they occur and not when work is undertaken or a liability is incurred. Ex: taxes should be discounted from their actual payment date. 2. Estimate cash flows on an incremental basis.
The value of a project depends on all the additional cash flows that follow from project acceptance. Some things to watch for when you are deciding which cash flows to include: a. Do not confuse average with incremental payoffs. you will sometimes encounter turnaround opportunities in which incremental NPV from investing in a loser is strongly positive. These benefits should be net of all other cost. b. Include all incidental effects. Sometimes a new project will help the firms existing business. c. Forecast sales today and recognize after-sales cash flows to come later. Many manufacturing companies depend on the revenues that come after their products are sold. d. Do not forget working capital requirements. Net working capital aka working capital is the difference between a company short term assets and liabilities.
Most projects entail an additional investment in working capital, which should be recognized in your cash flow forecasts. e. Include opportunity costs. Is the cash it could generate for the company if the project were rejected and the resource were sold or put to some other productive use, which prompts us to warn you against judging project on the basis of before vs after or with or without. f. Forget sunk costs. They are past and irreversible outflows, cannot be affected by the decision to accept or reject the project and so they should be ignored. g. Beware of allocated overhead costs. We should include only the extra expenses that would result from the project. h.
Remember salvage value. The salvage value represents a positive cash flow to the firm, but some have shut down costs in which case the final cash flows may be – 3. Treat inflation consistently investors that inflation into account when they decide what is an acceptable rate of interest, tax saving from depreciation do not increase with inflation. Discount nominal cash flows at a nominal discount rate. Discount real cash flows at a real rate. Never mix real cash flows with nominal discount rates or nominal flows with real rates. Operating cash flow= revenues-cash expenses-taxes
Separating investment and financing decisions: we analyze the project as if it were all equity financed, treating payments as cash outflows as coming from stockholders and all cash inflows as going to them, we do this to separate the investment decision from the financing decision. Investments in working capital: working capital increases in the early middile yearps of the project. working capital summarizes the net investment in short term assets associated with a firm, business, or project- the most important components are inventory, AR,AP. Working capital= inventory+ ar-ap
Working capital increases for several reasons:
1. Sales are increasing and customers are slow to pay their bills, A/R ^ 2. Age properly. As projected sales increase, larger inventories have to be held in the aging sheds. 3. Payments are delayed, which ^ A/P
Additional investment in working capital=increase in inventory+ increase in A/R – increase in A/P