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