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Chapter 5
Chapter 5
NPV
Capital allowances
-
Working capital
-
the relevant cash flows are the incremental cash flows from one years
requirements to the next. At the end of project the full amount invested
will be released
NPV layout
A neat layout will gain credibility in the exam and will help you make
sense of the many different cash flows that you will have to deal with.
Time
0
Salesreceipts
Costs
(X)
(X)
(X)
(X)
Saleslesscosts
Taxation
(X)
(X)
(X)
(X)
Capitalexpenditure
(X)
(X)
Scrapvalue
TaxbenefitofCAs
Workingcapital
(X)
(X)
(X)
(X)
Netcashflows
(X)
Discountfactors@
(X)
post-taxcostofcapital*
Presentvalue
Explanation
Ignoringinflation
Nominal or money
Includinginflation
InflationhastwoimpactsonNPV:
Time
0 1onwards
Cash flow
Discountfactor
Present value
tax on profits
tax on profits
Calculate
The
(i) Half the tax is payable in the same year in which the
profits are earned and half in the following year. This
reflects the fact that large companies have to pay tax
quarterly in some regimes.
(ii) Tax is payable in the year following the one in which the
taxable profits are made. Thus, if a projects increases taxable
profit by $10,000 in year 2, there will be a tax payment,
assuming tax at (say) 30%, of $3,000 in year 3.
(iii) Tax is payable in the same year that the profits arise.
each year.
2.Make
3.Calculate
and DCF
Tax exhaustion
Capital
allowances
liability
Tax liability = tax rate (Earnings before tax capital allowance)
When capital allowance in a particular year
equals or exceeds before tax earnings, the
company will pay no tax.
In most tax systems unused capital allowance
can be carried forward indefinitely.
Question: Capital allowance (p.162)
Capital rationing
Use trial and error and test the NPV available for different
combinations of projects
Capital rationing
Techniques
Expected values
Description
UsingprobabilitiestocalculateaverageexpectedNPV.
Risk adjusted
discount factor
Usingahighercostofcapitaliftheprojectishighrisk,
thisisdiscussedinthenextchapter.
Techniques
Description
Payback period
Thequickerthepaybackthelessreliantaprojectisonthelater,
moreuncertain,cashflows.
Ananalysisofwhat%changeinonevariable(egsales)would
beneededfortheNPVofaprojecttofalltozero.
CalculatedasNPVofproject/PVofsales(forexample)
Project duration
Ameasureofhowlongittakestorecoverapproximately half of
the value of the investment;itiscalculatedbyweightingeach
yearoftheprojectbythe%ofthepresentvalueofthecash
inflowsrecoveredinthatyear.
Simulation
Ananalysisofhowchangesinmorethan1parameters(eg
growthrateorcostofcapital)orvariablemayaffecttheNPVofa
project.
Savings ($)
(7000)
2,000
6,000
2,500
7,000
Required
Measure the sensitivity (in percentages) of the project to
changes in the levels of expected costs and savings.
duration
(100,000
)
45,455
36,346
26,296
13,660
6,209
Carlo method
Value at risk
Normal
distribution
losses
24
gains
Value at risk
Normal
distribution
5%
45%
1.645 std dev
losses
25
50%
0
gains
VAR
2.2.1
Example (p.170)
Step 1 calculate the NPV of the project at lower of the two rates
of return used
Step 2 calculate the project at higher of the two rates of return
used
Step 3 calculate the internal rate of return using the formula
Formula
NPVa
Re-investment rate
PV return phase
1 i 1
PV investment phase
Where
The
Alternative method
Ter min al value of return phase
MIRR
1
PV of investment phase
n
Where
The return phase is the phase of the project with cash inflows
(assuming cash flows are reinvested at the firms cost of
capital)
The investment phase is the phase of the project with cash
outflows
Use
Advantages of MIRR
Disadvantages of MIRR
MIRR, like all rate of return methods, suffer from the
problem that it may lead an investor for reject a project which
has a lower rate of return but, because of its size, generates
a larger increase in wealth.
In the same way, a high-return project with a short life may
be preferred over a lower-return project with a longer life.