3.6. NPV and cash flows. Some accounting details

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From the course by Moscow Institute of Physics and Technology

Principles of Corporate Finance – A Tale of Value

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Moscow Institute of Physics and Technology

Principles of Corporate Finance – A Tale of Value

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Course 2 of 5 in the Specialization Understanding Modern Finance

The study of Corporate Finance seems to be a very generic part of business education. Still, it either falls in the trap of intimidating formulas or is superficially journalistic. Both extremes preclude the understanding of the core finance ideas, concepts, and models. This Course is an attempt to avoid the above extremes. We discuss the core basis and mechanisms of modern corporate finance in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests and preferences of investors, reveal the true meaning of specific financial terms, and uncover important issues that are so often ignored in choosing and valuing investment projects. The learners will gain insight into the essence of corporate finance. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses.

From the lesson

Making the Choice of Good Investment Projects. NPV and Other Criteria. Why Is NPV Better?

We start Week 3 of the Course by the discussion of criteria of choosing investment projects. Beside NPV, the internal rate of return (IRR) and other approaches are introduced. We show why the NPV criterion is the best and why the application of others may lead to wrong investment decisions. Then we focus on the main ideas to be taken into account while setting up cash flow patterns and making the choice of project on the basis of NPV. We mention some special issues – relevant costs, depreciation, inflation. We present the concept of equivalent annual cost (EAC) as a method of comparing projects of different length. Then we study the application of EAC in greater detail in a case.

3.1. Why use NPV as a criterion of the choice of projects?5:53

3.2. Other criteria – pluses and minuses8:26

3.3. Internal rate of return (IRR)8:28

3.4. Problems with IRR – it’s not exactly like NPV!12:52

3.5. Using NPV – what should we know3:58

3.6. NPV and cash flows. Some accounting details11:39

3.7. Sunk costs – opportunity costs – relevant costs10:55

3.8. Depreciation – an overview relevant to cash flows5:51

3.9. Discount rates – nominal and real. The role of inflation6:02

3.10. Projects of different length. Equivalent annual cost (EAC)9:32

3.11. EAC – an example11:58

3.12. Conclusions and unanswered questions10:15

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

All right, let's proceed with our analysis of cash flows.

So Let's say about cash flows.

Well, the first of the most simplistic thing is that only

Cash flows are important.

What do we mean by that?

In reality, as we said, most information for

studying cash flow is taken from corporate accounts.

So we deal with accounting as a mechanism to describe

the financial position of a company.

And then we have to somehow extract cash flows from these accounting statements.

You can say, well,

one of the major accounting statements is the statement of cash flows.

So, basically, you can use that.

But if you dealt with that in reality, you would have found that dealing

with cash flow statements of the corporations is not such an easy job.

And oftentimes, it contains a lot of information that is not core for

the analysis investment project.

And on top of that, this is sort of accumulated and condensed.

And sometimes if you study a project within a corporation,

that would be of little use.

So the key story here is that you always

have to keep in mind that you're talking about cash flows.

We know why, because you can do a little bit with net income.

Net income is on paper, and

you can invest money only if this money is in the form of cash.

You can say, well, why then that accounting takes so

many efforts to describe the position of a corporation, or

any project with the use of so many specific ways, and

using sort of specific rules.

Why is that, that instead people are not using just cash accounting?

Then for us, it would be much easier to extract these numbers.

Well, this story we discussed in some greater detail in our third

course that is devoted to accounting issues that are important for

us in valuing lesson projects.

But for now, I can just that this is primarily because

these two approaches are different segments of stakeholders.

And what is great for just outside the or what is great for

the management of the company, is not so great for

their shareholders or their investors and general debt holders.

Because the key interest of these different stakeholder groups,

they require different approaches.

Now, what else is important here?

We have to realize that to the extent we would like to be able to compare

these cash flows, then you have to take them on an after tax basis.

So if you, let's say know exactly when this cash payment arrives

on your bank account, then you can do anything with that only after

you pay taxes to the government, or to the local government.

So that can be generalized that we are basically talking about free cash flows.

But this is not the same, because free cash flows sometimes,

then you also subtract investments.

But you have to be really careful about seeing what your inflows and

what your outflows are.

And so you keep in mind that these are cash flows in the first place.

And second of all, you have to realize what is sort of free

in terms of what can be used for investment.

And therefore for comparing with some other possible uses, and what cannot.

Now another important thing here

is Correct timing.

Because we know that in order to

use cash flows as inputs for calculating NPV,

you have to not only know how much money you will receive but also when.

And often times, if you're in a process of implementing a large scale project,

then the timing of these cash flow arrivals or

cash flow departures may not be the same as the phases on this project.

Again, that is sort of a hi

from accounting, when we talk about revenue and cost recognition.

And we talk about that in great detail later.

But for now, it must be kept in mind.

Now the next thing that we already mentioned before is this

incremental cash flows.

Well, here, I will give you an example.

If we could limit ourselves to the analysis of all the Greenfield projects.

So basically, when we start to do something from scratch,

then it will be much easier, because the background for

comparison would be just zeroes everywhere.

However, the reality is somewhat more complex.

And often times, you're analyzing, if you start this project,

and if you didn't, then you have to see what this if you didn't is.

Sometimes there are some other strategic considerations here that

make just plain vanilla financial approach sort of useless.

Let me give you an example.

Supposedly you have a bottling plant, and you're lucky.

And then your clients line up at your warehouse, so

there are trucks sitting there to just get your water.

And let's say your packaging line is already used for 110% capacity.

So you can unfortunately not produce more.

And you are thinking about what happens if you installed another,

let's say, expensive bottling line.

And you start to analyze that with use of the NPV approach.

And it may will be the case that if you use this investment right now,

and then you saw that actually, this is an expensive piece of equipment.

And then that might easily end up with a negative NPV.

But if you didn't do that, then these people with empty trucks sitting

close to your warehouses, at some point in time will just leave and

say, well, we'll buy water from someone else.

So if you did not do that, you might easily lose not

only these extra people lining up, but even your existing clients.

Because they could switch to someone else who actually delivers on what

this manufacturer or producer promises.

So this is not only a financial thing.

And although I produced an egregious example, but these examples,

well, I've had more than one of projects like that in my validation practice.

When the decisions were made

sometimes with the use of even potentially negative NPV projects.

And all that is studied in somewhat more detail in more

senior weeks of this course, when we talk about various

real options and how they contribute to value, and

how ignoring them may end up with incorrect result.

Now another thing that I would point out here is side effects.

That's close to what I was just talking about, and the idea here is as follows.

You can engage in a project, but this project may have some

by-products or side effects associated with that, both positive and negative.

Let's say you're building a railroad.

And this railroad, per say, has a negative NPV.

But if you did so then, this railroad connects two areas, and

that results in the economic boom in this region.

And this positive by-product may be more valuable

than just the fact of building this railroad.

Or it may be sort of the opposite.

Let's say you're building a compound of houses to be sold.

And then you realize that all those supply network of water,

of heating, of electricity is not sufficient to support it.

And then you not only have to build those houses, but

you also we have to invest heavily in infrastructure to make sure

that all these houses will have enough heat or electricity.

And if you ignore these side effects,

then it maybe a completely different result of the NPV calculation,

and therefore your decision to take on or not to take on this project.

And now, we are coming to the probably

most important part of that that we will discuss

in the special episode, because it deserves it.

This is cost treatment.

Because we said quite a few words about how we have to properly treat our inflows,

namely revenues, and how we have to worry about that this a cash component,

and how we have to really link that to income recognition.

But when it comes to cost, unfortunately, this whole story is much more

difficult to properly take into account, and that requires special attention.

Indeed, we talk about that in much more detail in our third course.

But for now, in the next episode, we will talk about that

in somewhat sufficient detail that allows you to use that properly.

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