Question

Explain the consequences of using incorrect project flows in coming up with your NPV answers. What criteria do you apply in getting the correct flows?

Answer 1

NPV is the net present value of present value of cash inflows over the initial investment. If NPV is positive the project is accepted else the project is rejected.

Using incorrect flows of can lead to different net present value computation and projects can be accepted or rejected. NPV is primarily computed by discounting of annual cash flows to present value based on cost of capital. Incorrect cash flows distort the net present value computation and can lead to capital allocation to non favorable projects

Criteria to be applied in getting the correct flows for NPV computation

· The initial investment cost should include purchase cost plus all installation cost , Increase in working capital and deducted for any after tax salve value of existing assets

· The cash flows should be computed after deducting cash operating costs from the cash savings or revenue.

· Depreciation should be adjusted for tax savings either though calculation of tax shield or if it is used in computation of taxable income should be added back to net income since it is non cash expense

· Release of working capital should be considered in terminal year

· After tax salvage value should be considered in terminal year.