Fundamentals of corporate finance 5e mcgraw chapter 08

Fundamentals of
Corporate
Finance

Chapter 8
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- 2

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

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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved


8- 3

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 2
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.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved


8- 4

Cash Flow vs. Accounting Income
Cash Income
Depreciation

Accounting Income

Year 1

Year 2

$1500

$ 500

- $1000 - $1000
+ 500

- 500

500
− 500
Apparent NPV =
+
= $41.32
2
1.10 (1.10)

McGraw-Hill/Irwin

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved


8- 5

Cash Flow vs. Accounting Income
Today
Cash Income
Project Cost
Free Cash Flow

- 2000
- 2000

Year 1 Year 2
$1500 $ 500
+1500

+ 500

- 2000 1500
500
Cash NPV =
+
+
= −$223.14
2
3
1.10 (110
. )
(110
. )

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8- 6

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- 7

Incremental Cash Flows
IMPORTANT
Ask yourself this question
Would the cash flow still exist if the project
does not exist?
If yes, do 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- 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- 9

Inflation
Example
You own a lease that will cost you $8,000 next
year, increasing at 3% a year (the forecasted
inflation rate) for 3 additional years (4 years
total). If discount rates are 10% what is the
present value cost of the lease?

1+nominal interest rate
1 + real interest rate =
1+inflation rate
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8- 10

Inflation
Example - nominal figures

Year Cash Flow

PV @ 10%

0

8000

8,000.00

1

8000x1.03 = 8,240

2

8000x1.032 = 8,487.20

8240
1.10
8487.20
1.10 2
8741.82
1.103

3

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
0
1
2
3

McGraw-Hill/Irwin

Cash Flow
8,000
8,000
8,000
8,000

%
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 incremental
analysis ask yourself the following
question: Is the project existence dependent
on the financing? If no, you must separate
financing and investment decisions.

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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
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

0
− 3,039

(,000s)
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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 0
- 10,000

Cap Invest
Salvage value
Change in WC
- 1,500
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
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