Hi, I have some questions about calculating NPV. Would anyone can give me some advice. When having a project, what is the criteria of deciding how many year of cash flow should be included in getting the NPV? For example, if the capital equipment for the project is $100,000 at the begining of year 2000, and it would be depreciated in equal amount over five years. So when we calculating the NPV, we should include the cash flow until 2004 when the BV of the equipment become zero? is it the criteria of the no. of year for calculating the NPV? If yes, is it because when the BV of the assets become zero, then it couldnt’ generate any cash inflow, so it would be the last year of the project? Thank you very much. Victor
it really just depends. if you’re calculating npv to compare different projects, one might have a life of four years before you have to buy another machine and the other might have six. if you don’t extend them until they are forecasted over the same number of years, your npv as a basis for deciding between the two is worthless. so basically, you would need to use a number of years that make sense given the circumstances. if the bv of the machine goes to zero but it still can generate cash flows, you could either model for the number of years until it stops generating cash flows, using a salvage value of zero, or you could use it until its fully depreciated and guess how much you could sell it for. hope this helps.
Don’t confuse regimes. Depreciation and book value belong to tax and financial accounting, which are generally of no use for running a firm (e.g., making project finance decisions). NPV attempts to model economics accurately. Book value of items or depreciation scheduled would never enter into such calculations. The specific answer to your question: you use all cash flows for the project.
tax depreciation–>cash taxes–>after-tax cash flow–> NPV
“Book value of items or depreciation scheduled would never enter into such calculations.” i think this is what voba is saying as well (maybe i’m misreading it), but bv determines how much you pay in taxes 1. over the life of the project and 2. when/if you sell it (is it a gain or loss that affects how much you pay in taxes?)
That’s a fair point. I just didn’t want Mr Lung terminating cash flows simply because he fell off the end of some depreciation time table.
Thanks for all your replies. Actually, i got these capital budgeting questions from my lecturer. The case is that, a company is proposing a project. The equipment cost would be $100,000 on Jan 2002. It would be depreciated to zero in 5 years. There are also on-going operational cost until the system was replaced. No alternative project for the case. One of the question is that “When valuing the prosposed investment, should value be included for possible cash flows that occur beyond 2007? What does it depend on?” My first guess about this question is, in 2007, there would be no BV for the equipment (is it equivalent to salvage value of zero?), so would it be the last year (or 2006) to calculate the cash flow? Because i though that if an asset has zero value , it couldn’t generate any cash inflow, if it could still generate cash flow, that mean the we need to revalue it to the market value. But to make the question simple, i assume that no revaluation is needed. DarienHacker, can you advice what is the meaning of “use all cash flows for the project”. How to judge how many years of cash flow should i use. Really thanks. VIctor
Hi All, Sorry for the long questions. I read the following from books: ---------------------------------- In Accounting, revenues and expenses is based on the “Matching Principles”, which means that revenues and expenses incurred to generate those revenues must be accounted for in the same time period. ---------------------------------- Does it mean if there is no expenses, the company couldnt’ generate revenue and cash inflow. Depreciation is a kind of expense, so if the asset is deprec. to zero, we couldn’t get any cash inflow generate by this asset, and therefore the investment is ended? Thanks again. VIctor
Depreciating an asset to 0 doesn’t necssarily have anything to do with its useful life or its value in producing income. In particular, you can depreciate things using different methods and depreciate things differently for taxes than for financial accounting. In any event that may not be an issue. Suppose they are buying equipment to build a dam that will generate power for 100 years. They depreciate the equipment over 5 years but the dam has value for 95 more years. In this case, the cash flows would even be reasonably predictable at least for awhile.