Today: Four Golden Rule in NPV Calculations

A real-world example
In late 1990, the Boeing Company announced its intention to build Boeing 777, a commercial airplane that would be able to carry up to 390 passengers and fly 7,600 miles. Analysts believed the upfront investment and R&D expenditures will cost $8 billion. Delivery of the first planes was expected in 1995 and continue for at least 35 years. Was the Boeing 777 a good project for Boeing? In 1990, was the NPV for the Boeing 777 positive?

Motivation Example

The Pierpont Companys trumpet plant: Revenues Operating Expenses Net Operating Income Depreciation Taxable Income Taxes Net Income $375,000 -$100,000 $275,000 -$200,000 $75,000 -$26,250 $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 a cash flow statement?

The following four golden rules give more detailed answers to these questions

Rule 1 After tax cash flows

Work with cash flow after taxes, not net income. This is the proper basis for a capital budgeting analysis..

Rule 1 Consequences
1. 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 of depreciation, 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 need to adjust for this.

Rule 2 Working Capital

Working Capital = Short-term assets short term liabilities Short term assets include:

Inventory Credit Sales - Accounts Receivable Credit Purchases Accounts Payable

Short term liabilities include:

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, although you dont have the money yet Your working capital increases: Accounts receivable increase by the value of the goods the customer will pay for in one year Calculating cash flow as sales minus change in working capital correctly reflects the deferred payment

Rule 3 use incremental cash flows

Only incremental cash flows are analyzed
We are interested in the difference between the 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 of overhead

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 $1 billion had already been spent. Some critics countered that it would be equally foolish to continue with a project that offered no prospect of a satisfactory return on that $1 billion already spent.

Rule 4 Inflation
Be consistent in the treatment of inflation:
Either discount nominal cash flows at a nominal discount rate, or discount real cash flows at a real discount rate

Rule 4 Example
Nominal Cash Flows
C0 -1000 C1 800 C2 1700

Projected rate of inflation = 40% p.a. Nominal interest rate = 50% p.a.

NPV

800 1,700 1,000 1 50 % 1 50 % 2 289

Rule 4 Example Real calculations

Nominal cash flow at date t Real cash flow at date t 1 inflation rate t

1 Nominal discount rate 1 Real discount rate 1 inflation rate

Rule 4 Example Real calculations

Nominal cash flow at date t Real cash flow at date t 1 inflation rate t
t=0
Nominal Cash Flows -1,000

t=1
800

t=2
1,700

(1+inflation rate)t
Real Cash Flows

1
-1,000

1.4
571.4

1.96
867.3

Rule 4 Example Real calculations

1 Nominal discount rate 1 Real discount rate 1 inflation rate
1 rreal rreal 1 50% 1 40% 0.0714 7.14%

571 .4 867 .3 NPV 1,000 289 2 1.0714 1.0714

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 rule 4, and you will see that it can be complicated

One of my favorite interview questions: How many 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 stations 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 1,000 cars 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.

Lets solve some of the practice questions from the lecture notes