Fundamentals of Corporate Finance Chapter Using Discounted Cash Flow Analysis to Make Investment Decisions Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- Topics Covered Identifying Cash Flows Discounted Cash Flows, Not Profits Incremental Cash Flows Treatment of Inflation Separate Investment & Financing Decisions Calculating Cash Flows Example: Blooper Industries McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- Cash Flow vs Accounting Income  Discount actual cash flows  Using accounting income, rather than cash flow, could lead to erroneous decisions Example A project costs $2,000 and is expected to last years, producing cash income of $1,500 and $500 respectively The cost of the project can be depreciated at $1,000 per year Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- Cash Flow vs Accounting Income Cash Income Depreciation Accounting Income Year Year $1500 $ 500 - $1000 - $1000 + 500 - 500 500 − 500 Apparent NPV = + = $41.32 1.10 (1.10) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- Cash Flow vs Accounting Income Today Cash Income Project Cost Free Cash Flow - 2000 - 2000 Year Year $1500 $ 500 +1500 + 500 - 2000 1500 500 Cash NPV = + + = −$223.14 1.10 (110 ) (110 ) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- Incremental Cash Flows  Discount incremental cash flows  Include All Indirect Effects  Forget Sunk Costs  Include Opportunity Costs  Recognize the Investment in Working Capital  Beware of Allocated Overhead Costs Incremental Cash Flow McGraw-Hill/Irwin = cash flow with project - cash flow without project Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- Incremental Cash Flows IMPORTANT Ask yourself this question Would the cash flow still exist if the project does not exist? If yes, not include it in your analysis If no, include it McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- Inflation INFLATION RULE Be consistent in how you handle inflation!! Use nominal interest rates to discount nominal cash flows Use real interest rates to discount real cash flows You will get the same results, whether you use nominal or real figures McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- Inflation Example You own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for additional years (4 years total) If discount rates are 10% what is the present value cost of the lease? 1+nominal interest rate + real interest rate = 1+inflation rate McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- 10 Inflation Example - nominal figures Year Cash Flow PV @ 10% 8000 8,000.00 8000x1.03 = 8,240 8000x1.032 = 8,487.20 8240 1.10 8487.20 1.10 8741.82 1.103 3 8000x1.03 = 8,741.82 = 7,490.91 = 7,014.22 = 6,567.86 $29,072.98 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- 11 Inflation Example - real figures Year McGraw-Hill/Irwin Cash Flow 8,000 8,000 8,000 8,000 PV@6.7961% 8,000 8,000 = 7,490.91 1.068 8,000 = 7,014.22 1.068 8,000 = 6,567.86 1.068 = $ 29,072.98 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- 12 Separation of Investment & Financing Decisions When valuing a project, ignore how the project is financed Following the logic from incremental analysis ask yourself the following question: Is the project existence dependent on the financing? If no, you must separate financing and investment decisions McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- 13 Blooper Industries Year Cap Invest 10,000 WC 1,500 Change in WC 1,500 Revenues Expenses Depreciation Pretax Profit Tax (35%) Profit 4,075 2,575 15,000 10,000 2,000 3,000 1,050 1,950 4,279 204 15,750 10,500 2,000 3,250 1137 , 2,113 4,493 214 16,538 11,025 2,000 3,513 1,230 2,283 4,717 225 17,364 11,576 2,000 3,788 1,326 2,462 3,039 − 1,678 18,233 12,155 2,000 4,078 1,427 2,651 − 3,039 (,000s) McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- 14 Blooper Industries Cash Flow From Operations (,000s) Revenues - Expenses 15,000 10,000 − Depreciation = Profit before tax 2,000 3,000 -Tax @ 35 % 1,050 = Net profit + Depreciation 1,950 2,000 = CF from operations 3,950 McGraw-Hill/Irwin or $3,950,000 Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved 8- 15 Blooper Industries Net Cash Flow (entire project) (,000s) Year - 10,000 Cap Invest Salvage value Change in WC - 1,500 CF from Op Net Cash Flow - 11,500 - 2,575 3,950 1,375 - 204 4,113 3,909 - 214 4,283 4,069 - 225 4,462 4,237 1,678 4,651 6,329 1,300 3,039 4,339 NPV @ 12% = $4,222,350 McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc All rights reserved [...]... − 3,039 (,000s) McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 8- 14 Blooper Industries Cash Flow From Operations (,000s) Revenues - Expenses 15,000 10,000 − Depreciation = Profit before tax 2,000 3,000 -Tax @ 35 % 1,050 = Net profit + Depreciation 1,950 2,000 = CF from operations 3,950 McGraw- Hill/Irwin or $3,950,000 Copyright © 2007 by The McGraw- Hill Companies,... dependent on the financing? If no, you must separate financing and investment decisions McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 8- 13 Blooper Industries Year 0 Cap Invest 10,000 WC 1,500 Change in WC 1,500 Revenues Expenses Depreciation Pretax Profit Tax (35%) Profit 1 2 3 4 5 6 4,075 2,575 15,000 10,000 2,000 3,000 1,050 1,950 4,279 204 15,750 10,500... Example - real figures Year 0 1 2 3 McGraw- Hill/Irwin Cash Flow 8,000 8,000 8,000 8,000 PV@6.7961% 8,000 8,000 = 7,490.91 1.068 8,000 = 7,014.22 1.068 2 8,000 3 = 6,567.86 1.068 = $ 29,072.98 Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved 8- 12 Separation of Investment & Financing Decisions When valuing a project, ignore how the project is financed Following the logic from... CF from Op Net Cash Flow - 11,500 1 - 2,575 3,950 1,375 2 - 204 4,113 3,909 3 - 214 4,283 4,069 4 - 225 4,462 4,237 5 1,678 4,651 6,329 6 1,300 3,039 4,339 NPV @ 12% = $4,222,350 McGraw- Hill/Irwin Copyright © 2007 by The McGraw- Hill Companies, Inc All rights reserved