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Making Investment Decisions with the Net Present Value Rule

Making Investment Decisions with the Net Present Value Rule

Up to this point we have been concerned mainly with the mechanics of discounting and with the net present value rule for project appraisal. We have glossed over the problem of deciding what to discount. When you are faced with this problem, you should always stick to three general rules:

1. Only cash flow is relevant.

2. Always estimate cash flows on an incremental basis.

3. Be consistent in your treatment of inflation.

We will discuss each of these rules in turn.

The first and most important point: Net present value depends on future cash flows. Cash flow is the simplest possible concept; it is just the difference between dollars received and dollars paid out. Many people nevertheless confuse cash flow with accounting profits.

Accountants start with “dollars in” and dollars out, but to obtain accounting income they adjust these inputs in two important ways. First, they try to show profit as it is earned rather than when the company and the customer get around to paying their bills. Second, they sort cash outflows into two categories: current expenses and capital expenses. They deduct current expenses when calculating profit but do not deduct capital expenses. Instead they depreciate capital expenses over a number of years and deduct the annual depreciation charge from profits. As a result of these procedures, profits include some cash flows and exclude others, and they are reduced by depreciation charges, which are not cash flows at all.

It is not always easy to translate the customary accounting data back into actual dollars—dollars you can buy beer with. If you are in doubt about what is a cash flow, simply count the dollars coming in and take away the dollars going out. Don’t assume without checking that you can find cash flow by routine manipulations of accounting data.

Always estimate cash flows on an after-tax basis. Some firms do not deduct tax payments. They try to offset this mistake by discounting the cash flows before taxes at a rate higher than the opportunity cost of capital. Unfortunately, there is no reliable formula for making such adjustments to the discount rate.

You should also make sure that cash flows are recorded only when they occur and not when work is undertaken or a liability is incurred. For example, taxes should be discounted from their actual payment date, not from the time when the tax liability is recorded in the firms books.

The value of a project depends on all the additional cash flows that follow from project acceptance. Here are some things to watch for when you are deciding which cash flows should be included:

Do Not Confuse Average with Incremental Payoffs Most managers naturally hesitate to throw good money after bad. For example, they are reluctant to invest more money in a losing division. But occasionally you will encounter turnaround opportunities in which the incremental NPV on investment in a loser is strongly positive.

Conversely, it does not always make sense to throw good money after good. A division with an outstanding past profitability record may have run out of good opportunities. You would not pay a large sum for a 20-year-old horse, sentiment aside, regardless of how many races that horse had won or how many champions it had sired.

Here is another example illustrating the difference between average and incremental returns: Suppose that a railroad bridge is in urgent need of repair. With the bridge the railroad can continue to operate; without the bridge it cant. In this case the payoff from the repair work consists of all the benefits of operating the railroad. The incremental NPV of such an investment may be enormous. Of course, these benefits should be net of all other costs and all subsequent repairs; otherwise the company may be misled into rebuilding an unprofitable railroad piece by piece.

Include All Incidental Effects It is important to include all incidental effects on the remainder of the business. For example, a branch line for a railroad may have a negative NPV when considered in isolation, but still be a worthwhile investment when one allows for the additional traffic that it brings to the main line.

These incidental effects can extend into the far future. When GE, Pratt & Whitney, or Rolls Royce commits to the design and production of a new jet engine, cash inflows are not limited to revenues from engine sales. Once sold, an engine may be in service for 20 years or more, and during that time there is a steady demand for replacement parts. Some engine manufacturers also run profitable service and overhaul facilities. Finally, once an engine is proven in service, there are opportunities to offer modified or improved versions for other uses. All these downstream activities generate significant incremental cash inflows.

Do Not Forget Working Capital Requirements Net working capital (often referred to simply as working capital) is the difference between a companys shortterm assets and liabilities. The principal short-term assets are cash, accounts receivable (customers unpaid bills), and inventories of raw materials and finished goods. The principal short-term liabilities are accounts payable (bills that you have not paid). Most projects entail an additional investment in working capital. This investment should, therefore, be recognized in your cash-flow forecasts. By the same token, when the project comes to an end, you can usually recover some of the investment. This is treated as a cash inflow.

Include Opportunity Costs The cost of a resource may be relevant to the investment decision even when no cash changes hands. For example, suppose a new manufacturing operation uses land which could otherwise be sold for $100,000. This resource is not free: It has an opportunity cost, which 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.

This example prompts us to warn you against judging projects on the basis of before versus after. The proper comparison is with or without. A manager comparing before versus after might not assign any value to the land because the firm owns it both before and after:

Decs.1.jpg

The proper comparison, with or without, is as follows:

Decs.2.jpg

Comparing the two possible afters, we see that the firm gives up $100,000 by undertaking the project. This reasoning still holds if the land will not be sold but is worth $100,000 to the firm in some other use.

Sometimes opportunity costs may be very difficult to estimate; however, where the resource can be freely traded, its opportunity cost is simply equal to the market price. Why? It cannot be otherwise. If the value of a parcel of land to the firm is less than its market price, the firm will sell it. On the other hand, the opportunity cost of using land in a particular project cannot exceed the cost of buying an equivalent parcel to replace it.

Taken from Principles of Corporate Finance by Richard A. Brealey and Stewart C. Myers (7th edition)

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