(2 of 14) Ch.10 - Relevant vs irrelevant cash flows - YouTube

So, because you will be working with a lot of information for the year when the project

would begin and all the way through the final year of the project, we need to first know

how to identify what's relevant and what's irrelevant.

Irrelevant means we can ignore those dollar amounts.

We can cross them out.

They're not going to be used in our net present value calculations.

So, here I have a few examples, taxes, lost revenues from existing projects, wages to

employees, depreciation expense, money paid to consult us, initial purchase price, interest

payments on debt.

So, these are not, you know, the only type of cash flows we will be working with.

This is just an example, like a small set of all the information for a project.

It turns out some of these are actually called irrelevant to project valuation, which means

we don't need to worry about them.

We can cross them out and forget about them.

We will not use them in our NPV calculations, so which are relevant and which are irrelevant.

That's the topic on the next couple of slides.

Taxes, they are very important.

We must pay taxes on our corporate income.

Wages to employees without employing people, we will not be able to produce the product

that we are planning to sell, you know, in this project.

Lost revenues from existing projects, well, if by implementing some new project, we're

going to see lost sales from something else we already have.

That's an important, you know, consideration, right?

So, this is also irrelevant type cash flow.

Depreciation, initial purchase price, interest payments on debt, money paid to consultants.

So, let me just speed it up a little bit and say that a month this-- one, two, three, four,

five, six, seven examples, there are two which are irrelevant.

And these two are money paid to consultants and interest payments on debt.

It might look strange why this would be unimportant.

So, money paid to consultants, paid, right?

This verb is in the past.

This is the money that has already been paid before we are making our decision to accept

or reject the project, right?

So, it's not like if we decide to reject this project because the NPV is negative, we would

then come back to our consultants that we were working on some, you know, maybe market

analysis related to this project and ask them to pay us the money back, right?

This money will not be recovered anymore whether the project is accepted or rejected.

And because it already occurred in the past and cannot be recovered, we call it a sunk

cost.

So, money paid to consultants is an example of what we call a sunk cost and sunk costs

are irrelevant to project valuation.

So, if there is something that looks like money that has already been spent in the past

before the decision on the project is made, then you should cross that number out from

your list and you will not be using it anywhere in your net present value calculations.

Now, why are interest payments on that also considered irrelevant?

I would say there are a couple of ways to explain it.

First, interest payments on debt are financial expenses.

They're not so-called operating expenses which are necessary to produce the product.

Interest payments on debt like making payments on a loan, right?

And maybe we took a loan to cover part of the initial cost like buying any sort of furniture

or equipment or buildings, right?

So why are interest payments considered irrelevant?

Another reason is other than being sort of a different category of cash flows, not operating

but financing, you can also say that taking a loan is kind of an optional thing.

If the company had money, it would not need to take a loan, right?

And in that case, what would the cash flows that are, you know, really required for the

project and exclude any sort of interest payments that are kind of-- not very necessary?

What would the cash flows then tell us about the acceptability of this project?

So, interest payments on debt and the money that has already been paid like paid to consultants

or maybe research and development are the two cash flows that we are going to treat

as irrelevant to project valuation.

Another way you can explain what relevance refers to is you can say that relevant cash

flows are incremental cash flows.

The word incremental means additional.

Additional to what?

Additional to a firm's existing cash flows, right?

So, incremental or relevant cash flows are cash flows that are incremental to a firm's

existent cash flows, right, on the projects that it already has running and that are a

direct consequence of taking this project.

You can also say that incremental cash flows will only occur if the project is accepted.

And incremental cash flows should be included in a capital budgeting analysis.

In other words, in calculating the net present value for some investment opportunity.

There is also another, you know, a little topic that's related to cash flows being irrelevant

or not called the stand-alone principle.

What do this mean-- What this means is we need to be analyzing each project in isolation

from the firm, simply by focusing on these incremental cash flows.

In other words, imagine we have a restaurant chain.

It currently has 10 restaurants, right?

And it's now considering whether it should open one more restaurant in the area, the

11thone.

So, rather than calculating the net present value from all future, you know, cash flows

coming from all 11 restaurants and comparing that to the net present value coming from,

you know, revenues from the current 10 restaurants, we should instead look at the 11th restaurant

only, kind of isolated from everything else unless, of course, it has some impact on our

existing restaurants.

So maybe by opening the 11th restaurant, we are going to lose some sales from-- in other

restaurant that's close, you know, the closest to it, something that also belongs to us,

right?

Then the 11th restaurant has, you know, this negative impact on the sales from our-- one

of our currently operating restaurants and that part would need to be considered.

OK.

So, in this table here, I kind of tried to summarize, you know, different terms used

for different types of cash flows.

The first two roles include sum costs and financing costs.

And these are the two cash flows that I put "no", for in the last column in this table.

"No" means not relevant, right?

So, sum costs are those expenses that have already occurred.

They're not recoverable even if the project is rejected.

An example includes money paid to consultant firm to do some sort of preliminary, maybe

get a data collection, data gathering and analysis, research and development, R and

D and so on.

Then second, financing cost also treated as irrelevant.

That's essentially anything related to taking a loan and paying back to the lender.

So, interest expenses.

We are going to ignore them.

Right.

So, if we decided to take a loan or sell bonds to borrow money for our new project then these

are the kind of numbers that would be ignored in our net present value calculation.

Then I have side effects, also known as spillover effects or project externalities.

There are two types of side effects.

A negative effect on a firm's existing product is called erosion.

A positive effect on a firm's existing project or product is called synergy.

Let me give you an example.

So, let's say 10 years ago roughly when Apple was, you know, considering selling iPhones

for the first time, right?

I'm pretty sure Apple was realizing that when iPhones would start selling, iPod sales would

drop, right?

So, there would be less money coming in from selling iPods which was Apple's existing product.

This is an example of erosion.

On the other hand, Apple was probably realizing that if iPhones become a big hit, then people

who love iPhones might start spending more money on buying other Apple products like

paying for songs in iTunes, buying Mac computers and other Apple products.

This is an example of the so-called synergy effect.

And both the erosion and the synergy, you know, cash flows are relevant to project calculation.

In this chapter, we are actually never going to look at any numerical problems which have

something so complicated going on like the whole erosion or synergy but it's just, you

know, so at least I won’t have them on my slides.

Maybe in the homework a little example but nothing like a full-blown net present value

over multiple years, nothing of that scale.

Opportunity costs are also relevant.

It means forgone revenues from an alternative project.

So maybe we are currently considering converting a park lot into an office building.

That's our project for which we are trying to calculate the net present value but an

alternative to that would be selling the lot and making some money.

So, the money that we could have instead received from selling this parking lot should be included,

you know, when we are calculating this sort of overall kind of the net initial investment

into, you know, this office building project.

Net working capital, NWC is another type of relevant cash flow.

By definition, net working capital equals current assets, minus current liabilities.

Current assets include things like cash or other more or less small items that can be

converted into cash quickly and easily such as inventory and accounts receivable.

Current liabilities include short term loans, short term means it needs to be paid back

within one year and current liabilities also include accounts payable, so the money that

a firm owes to its suppliers, again, within maybe a few weeks or a few months.

So, net working capital as related to, you know, the whole funding the net present value

for a new project, includes things-- examples like, maybe right away if we decide to launch

this project, we would need to set aside a few hundred dollars in cash, right?

Or maybe we would need to buy inventory or do something with accounts payable or accounts

receivable but just think about cash only.

It's sort of the easiest thing to explain.

So if you decide to set aside cash, then it's treated as an investment towards the project,

right?

And maybe as we start using our equipment or building, whatever assets we have, we would

need to acquire right away.

As we use them more and more and more, we would need to be prepared to spend even more

cash to cover any unforeseen expenses in the future.

So maybe this cash reserve would need to be increased over time.

And that means investing even more and more and more into this net working capital type,

you know, cash flow.

So, net working capital, changing net working capital throughout the project’s life is

irrelevant cash flow.

Then it's probably intuitive that taxes, so paying taxes on corporate income, let's say

at 34% or something like that is also a very important cash flow, a very important expense

that all firms have to face.

And then things like sales revenue, cost of production which include fixed costs and variable

costs.

The initial investment, then depreciation, which is needed to find how much taxes we

will owe to the IRS.

Then we have this term salvage value which will come up in maybe 10, 15 slides.

Salvage value is essentially when the project ends, how much money do we get when we sell

all our assets like the building, the equipment and etcetera?

And all those are also relevant.