- Free cash flows and the discount rate
Free cash flows are available to service both the shareholders and the debt holders. Therefore, debt flows (interest charges and repayment of principle) are not considered in the computation of free cash flows. The financing effect is captured by the firm’s weighted cost of debt and equity, which is used to discount the project’s cash flows. This approach is based on two assumptions:
- The project’s risk is the same as the firm’s risk
- The firm’s debt ratio is consistent and the project’s debt capacity is the same as the firm’s.
- Terminal cash flows
Terminal cash are those, which occur in the projects last year in addition to annual cash flows. They would consist of the after tax salvage value of the project and working capital released (if any). In case of replacement decision, the foregone salvage value of old asset should also be taken into account.
- Terminal value of new product
Terminal value of new product may depend on the cash flows, which could be generated much beyond the assumed analysis or horizon period. The firm may make reasonable assumption regarding the cash flow growth rate after the horizon period.
- Incremental cash flows
The term incremental cash flows should be interpreted carefully. The concept should be extended to include the opportunity cost of the existing facilities used by the proposal. Sunk cost and the allocated overheads are irrelevant in computing cash flows. Similarly, a new project may cannibalize sales of the existing products. The project’s cash flows should adjust for the reduction in cash flows on account of the cannibalization.
- Inflation
The net present value (NPV) rule gives correct answer to choose an investment under inflation if it is treated consistently in cash flows and discount rate. The discount rate is a market determined rate and therefore, includes the expected inflation rate. It is thus generally stated in nominal terms. The cash flows should also be stated in nominal terms to obtain an unbiased net present value (NPV). Alternatively, the real cash flows can be discounted at the real discount rate to calculate unbiased net present value (NPV).
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