Four Golden Rules in NPV calculations.ppt

7/27/2019 Four Golden Rules in NPV calculations.ppt

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Today: Four Golden Rule in NPVCalculations



A real-world exampleIn late 1990, the Boeing Company announced itsintention to build Boeing 777, a commercial

airplane that would be able to carry up to 390passengers and fly 7,600 miles. Analysts believedthe upfront investment and R&D expenditures willcost $8 billion. Delivery of the first planes was

expected in 1995 and continue for at least 35years. Was the Boeing 777 a good project forBoeing? In 1990, was the NPV for the Boeing 777positive?



Motivation Example The Pierpont Company’s trumpet plant:

Revenues $375,000Operating Expenses -$100,000Net Operating Income $275,000Depreciation -$200,000Taxable Income $75,000

Taxes -$26,250Net Income $48,750

Should the firm build the plant?



Capital Budgeting – the four rules to

remember

What are the relevant cash flows to discount?

How do we transform accounting data into acash flow statement?

The following four “golden” rules give moredetailed answers to these questions



Rule 1 – After tax cash flows

Work with cash flow after taxes, not netincome. This is the proper basis for a

capital budgeting analysis..



Rule 1 – Consequences1. Estimate cash flows on an after-tax basis

2. Treatment of depreciation Depreciation does not have a direct cash flow effect

But: You save taxes due to the tax deductibility ofdepreciation, and that is an indirect cash flow effect

3. Ignore interest and dividend payments



Rule 2 – Timing of Cash Flows

The timing of cash flows is critical.Revenues and costs include cash you

have not received or paid out. You needto adjust for this.



Rule 2 – Working Capital Working Capital = Short-term assets –

short term liabilities

Short term assets include: Inventory

Credit Sales - Accounts Receivable Short term liabilities include:

Credit Purchases – Accounts Payable



What is Working Capital? Example:

You sell goods and allow the customer to pay you one

year later You record the goods sold in the sales figure

You use the sales figure in your calculation of revenues, althoughyou don’t have the money yet

Your working capital increases: Accounts receivable increase bythe value of the goods the customer will pay for in one year

Calculating cash flow as sales minus change in working capitalcorrectly reflects the deferred payment



Rule 3 – use incremental cash flowsOnly incremental cash flows are

analyzed

We are interested in the difference betweenthe cash flows of the firm with the project

and the cash flows without the project



Rule 3 - Details

1. Include all incidental effects (Erosion

or Synergy)2. Forget sunk costs

3. Include opportunity costs

4. Be careful in the allocation ofoverhead



Rule 3 – Sunk costs – Example In 1971, Lockheed sought a federal

guarantee for a bank loan to continue

development of the TriStar airplane Lockheed and its supporters argued it would be

foolish to abandon a project on which nearly $1billion had already been spent.

Some critics countered that it would be equallyfoolish to continue with a project that offered noprospect of a satisfactory return on that $1 billionalready spent.



Rule 4 – InflationBe consistent in the treatment of

inflation:

Either discount nominal cash flows at a

nominal discount rate, or discount real cashflows at a real discount rate



Rule 4 – ExampleNominal Cash Flows

C0 C1 C2

-1000 800 1700

Projected rate of inflation = 40% p.a.

Nominal interest rate = 50% p.a.

289

%501

700,1

%501

800000,1

2

NPV



Rule 4 – Example – Real calculations

t

rateinflation1

tdateatflowcash Nominal tdateatflowcashReal

rateinflation1

ratediscount Nominal1 ratediscountReal1




t rateinflation1

tdateatflowcash Nominal tdateatflowcashReal

t = 0 t = 1 t = 2 Nominal Cash Flows -1,000 800 1,700 (1+inflation rate)t 1 1.4 1.96 Real Cash Flows -1,000 571.4 867.3




rateinflation1

ratediscount Nominal1 ratediscountReal1

%14.70714.0

%401

%5011

real

real

r

r

289

0714.1

3.867

0714.1

4.571000,1

2 NPV



Rule 4 – Practical Aspects

U.S. Tax Code is written in nominal terms

Work out depreciation in nominal terms, and

then convert it Pay attention to whether numbers are given in

real or in nominal terms

The Pistachio case is a direct application of rule4, and you will see that it can be complicated

f f



One of my favorite interview questions: Howmany gas stations are there in the US?

Difficult, because you need to aggregate along two dimensions,

cars and profit per station. Here is one suggestion: Gas station’s profit

Average car drives 15,000 miles / year (from average lease contract)

Average car drives 20 miles per gallon

Average car needs 15,000 / 20 mpg = 750 gallons of gas per year

Say gas station makes 10 cents per gallon profit – therefore per car$75 profit

Say 1 gas station needs to make $75,000 from gas a year or 1,000cars per year (plus everything they make from cross-selling of food /souvenirs)

How many cars are in the US? 280 million people live in roughly 100 million households

Say every household has on average two cars (probably generous)

That means there are 200 million cars in the US

Overall, there are then 200 million cars / 1,000 cars per gas station

= 200,000 gas stations in the US.



Let’s solve some of the practicequestions from the lecture notes

Four Golden Rules in NPV calculations.ppt

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