EFN507 Chap.4 Project Cash Flows, Inflation and Operating Leverage
Project Cash Flows, Inflation and Operating Leverage
Getting the numerator right
Every NPV in the unit is only as good as its cash flows.
Week 3 builds them after tax and unlevered: depreciation is deducted to compute tax and then added back, money already spent is ignored, space or equipment the project takes from other uses is charged at its opportunity cost, working capital is an outflow while it builds and an inflow when it is released, and salvage is counted after tax.
Interest stays out, because financing enters through the discount rate.
Inflation and risk
Nominal cash flows must meet a nominal rate and real cash flows a real rate; done consistently, both give the same NPV, but the depreciation tax shield is fixed in nominal dollars and shrinks in real terms.
The coordinator's note on operating leverage then asks whether revenue, variable costs and fixed costs deserve one rate. Because betas add up, a project with heavy fixed costs has a higher beta than its revenue, so it needs a higher discount rate than a firm-wide figure.
What this chapter covers
- 01
After-tax, unlevered cash flows and the depreciation tax shield
- 02
Sunk costs, opportunity costs, salvage and why interest is excluded
- 03
Working capital that builds with revenue and is recovered at the end
- 04
Nominal versus real forecasts and the matching discount rates
- 05
Valuing revenue, variable costs and fixed costs at separate rates
- 06
How operating leverage raises a project's beta
Worked example · free
Operating leverage and the project discount rate
- +1Discount revenue and variable costs at 4% + 6% = 10%: PV(R) = $10,000 and PV(VC) = $5,000.
- +2Discount fixed costs at the 4% risk-free rate: PV(FC) = 100 ÷ 0.04 = $2,500.
- +2PV(NCF) = 10,000 − 5,000 − 2,500 = $2,500, and beta = 1.0 × (1 + 2,500 ÷ 2,500) = 2.0.
- +1The discount rate is 4% + 2.0 × 6% = 16%; check: net cash flow $400 ÷ 0.16 = $2,500.
Key terms
- Depreciation tax shield
- The tax saved because depreciation reduces taxable income, equal to the tax rate times the depreciation charge.
- Sunk cost
- Money already spent that no current decision can recover, and so is excluded from project cash flows.
- Net working capital
- Current assets such as inventory and receivables less current liabilities, cash tied up by operations.
- Real discount rate
- The rate of return after removing inflation, found from one plus the nominal rate divided by one plus inflation.
- Fixed costs
- Costs that do not vary with the volume of output, though they may change from period to period.
Project Cash Flows, Inflation and Operating Leverage FAQ
Why is interest left out of project cash flows?
Financing is captured by the discount rate. If you subtract interest from the cash flows and then discount at a weighted average cost of capital, the benefit of debt is counted twice, once in each place, and the project is overvalued.
How should working capital enter an NPV?
As an outflow when the investment in inventory and receivables is made, usually before sales begin, plus further outflows as revenue grows, and as an inflow when the balance is run down at the end. The flows sum to zero; their cost is the time value of money.
Do nominal and real methods really give the same NPV?
Yes, when every line is treated consistently. Nominal flows discounted at the nominal rate and real flows discounted at the real rate differ only by the inflation factor top and bottom. Mixing them, real forecasts at a nominal rate, gives a wrong answer.
Why does the depreciation tax shield behave differently under inflation?
Depreciation is based on the original cost of the asset, so the tax saving is fixed in nominal dollars. In real terms it therefore shrinks each year as prices rise, unlike revenue and costs, which grow with inflation.
What is operating leverage?
The extent to which a project's costs are fixed rather than variable. Fixed costs do not fall when sales fall, so they magnify the swings in net cash flow, raising the project's beta in the same way that borrowing raises the beta of equity.
Should a firm use one discount rate for all its projects?
Only if the projects share the same risk. The coordinator's note shows that a project with very different operating leverage from the firm's existing assets has a different beta, so applying the company-wide cost of capital would misprice it.
Exam move
Build one project's cash flows in a spreadsheet twice, in nominal and in real dollars, and confirm the NPVs match. Then value the revenue, variable and fixed costs of a perpetual project separately and recover its beta.
Working through Project Cash Flows, Inflation and Operating Leverage in EFN507? Sia is AskSia’s AI Finance tutor — ask any EFN507 Project Cash Flows, Inflation and Operating Leverage question and get a clear, step-by-step explanation grounded in how EFN507 is taught and assessed. Read this chapter free, then take your hardest questions to Sia.
