Investment Banking and Delisting
It is common knowledge that investment bankers help a company when they want to list their shares on the stock exchange. This process is called listing, and there are hundreds of companies that undertake this process every year. However, the opposite of this process also happens. This means that companies that are already publicly listed […]
Valuation Divergence – Meaning and its Importance
For any startup financing to be successful, the startup company and the investors need to be on the same page about a lot of issues. This is because, in the absence of this understanding, valuation divergence can be a quagmire of ever-escalating tensions between the two parties. One major source of conflict between these two […]
The End of the Dollar Hegemony
The dollar today is the uncrowned king of the financial world. This means that the dollar does not face much of competition from other currencies as on date. However, that does not mean that the dollar is invincible. Economies all over the world today are tired of the United States imposing its military and financial […]
The Use of Reference Rates in Financial Markets
Debt securities are widely issued and traded in the secondary market. Debt securities could have a fixed interest rate or a floating interest rate. When debt is taken for the short term, fixed interest rates are preferred. However, in the medium to long run, the interest rates cannot be directly fixed. This is because, as […]
What are Eurobonds?
The Eurobond market is one of the largest debt markets in the world. It comprises a large portion of the debt which is issued by multinational companies as well as governments. It is therefore important for any student of fixed income securities to be aware of what Eurobonds are. The fact that these bonds are […]
Continuing from the previous two articles, we will look at some more counterintuitive steps that need to be taken to calculate the cash flows which should then be discounted to arrive at the worth of the project. This article will cover the concepts of how sunk costs should be treated as well as how allocated overheads may at times be different from the overhead value that we have to use in our cash flow calculations.
Sunk costs are expenses that have happened in the past that will not be affected by the current decision. The second part is very important. Defining sunk costs just as expenses that have happened in the past would be inappropriate if our current decisions affect them.
Consider a case when the firm has already spent $1 million on a project. However, the project has turned out to be unsuccessful till date. It has not churned out any positive cash flows till date. Now, the company is faced with a choice. The choice is whether it should invest more in the project that it has spent $1million on or whether it should pursue a new project.
The important point is not the answer. The important point here is the thought process that will be used to arrive at the answer. The correct thought process understands that $1m already spent has nothing to do with the new choice they are faced with. The incremental dollars also deserve their best use and hence the decision must be taken solely on the basis of NPV of additional money that is going to be spent. The old $1m is not affected by the decision that has to be taken now. Hence it is irrelevant and must be completely ignored during the decision making.
Overheads are costs that cannot be assigned to any activity directly. Assigning them within the company’s different departments and projects therefore becomes a problem. This problem is solved by accountants through the concept of allocation. Since the track of where the money was actually spent cannot be kept, accountants assume a basis and costs are allocated on that basis. The problem is that these allocated costs may not be good for our cash flow analysis purpose.
For instance, consider the fact that there are 3 departments A, B and C. The total overheads of the company now are $100. The allocation base used is labor hours and the proportion in which these costs are split is 2:2:1. Hence A, B and C have allocated overheads of $40, $40 and $20.
Now, consider what happens when the 4th department is introduced. The fourth department has an additional overhead cost of $20 taking total overheads to $120. However, based on the labor hours basis the new ratio is 3:3:1:3
Based on this the overheads allocated to department A, B, C and D are $36, $36, $12 and $36 respectively. So, for department D, we have an allocated overheads cost of $36 as opposed to incremental overheads cost of $20. Since, cash flow analysis is all about incremental costs, it is essential that we take into consideration the incremental costs and not the allocated costs while performing the calculations.
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