Semih Yildirim ADMS 3530 8 - 1 Chapter 8 Using Discounted Cash Flow Analysis Chapter Outline Discount Cash Flows, Not Profits Discount Incremental

Semih Yildirim ADMS 3530

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Chapter 8Using Discounted Cash Flow Analysis

Chapter Outline Discount Cash Flows, Not Profits Discount Incremental Cash Flows Discount Nominal Cash Flows by the Nominal

Cost of Capital Separate Investment and Financing Decisions Calculating Cash Flow Business Taxes in Canada and the Capital

Budgeting Decision Example: Blooper Industries


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Discount Cash Flows not Profits In Chapter 6 you learned to evaluate a project:

Step 1: Forecast the projected cash flows. Step 2: Estimate the opportunity cost of capital. Step 3: Discount the cash flows at the opportunity

cost of capital.

Step 4: Calculate the NPV where

NPV = PV of Cash flows – Initial Investment

Decision: Go ahead with the project if NPV 0. In this chapter, you will learn how to prepare cash flow

estimates for use in a NPV analysis. That is we will discount cash flows not accounting profits.


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Discount Cash Flows not Profits Remember, forecasts of cash flows will not arrive on a

silver platter, all ready to go into your analysis! You will have to deal with raw data supplied by consultants,

production, marketing, etc. You will also have to adjust data prepared in accordance with

accounting principals. Accounting numbers use historic costs and accounting income, not

market values and CFs, which are necessary for a NPV analysis. Discounting accounting income, rather than cash flow, will

lead to erroneous decisions. For example: A projects cost $2,000 (C0) and has an

opportunity cost of capital of 10%. It has a 2 year life. It will produce cash revenues of $1,500 and $500. The project can be depreciated at $1,000 per year. Compare the NPV using cash flow to the NPV using accounting

income.


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t=0 t=1 t=2Cost (C0) (2,000)Cash Income 1,500 500Cash Flow (2,000) 1,500 500

Cash Income - 1,500 500Depreciation - (1,000) (1,000)Accounting Income - 500 (500)

Discount Cash Flows• Discount Cash Flows not Profits


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Discount Cash Flows• Discount Cash Flows not Profits

Accounting NPV:

+500 + -500

1.10 1.102

= $41.32

-2,000 + 1,500 + 500

1.10 1.102

= -$223.14

ACCEPT THE PROJECT

REJECT THE PROJECT

NPV of Cash Flow:


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Discount Cash Flows not Profits Discounting the accounting income gives an entirely

different result from discounting the cash flows! The Accounting NPV says to accept the project. However, this answer makes no sense:

The project is obviously a loser, since we only get our money back ($1,500 + $500 = $2,000 or the cost).

This means we are getting a zero return when we could be getting 10% in the market!

The NPV of the cash flows gives the correct answer: This project is undesirable and should be rejected!

Remember: Projects are attractive because of the cash flow they generate. Therefore, the focus of capital budgeting must be cash flows and not

profits.


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Discount Incremental Cash Flows• Look for Incremental Benefits

A project’s NPV depends on the extra cash flows it produces.

You should:1. Calculate the firm’s cash flows if it goes ahead with the project.2. Calculate the cash flows if the firm doesn’t go ahead with the

project.3. Take the difference, which gives you the extra, or incremental,

cash flow of the project.

Incremental Cash Flow =Cash Flow

with the Project

Cash Flow without the

Project -


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Discount Incremental Cash Flows

• Look for Incremental Benefits You may wish to ask yourself:

Would this cash flow still exist if the project did not exist?

No?

Include the cash flow in the analysis.

Yes?

Do not include the cash flow in the analysis.


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Discount Incremental Cash Flows• Look for Incremental Benefits

Intel is considering launching the Pentium 4 microprocessor. Cash flows from the sale of the new processors are expected to

be in the billions. But, will these be incremental cash flows?

Our with-versus-without principle means we must also think about the cash flows without the new processor.

If Intel goes ahead with the new processor, then demand for Pentium 3 chips will fall.

Cash flows from the sale of Pentium 4 chips must be reduced by the decrease in cash flows from Pentium 3 chips.

= -IncrementalCash Flow

Cash Flow from P4

(including reduced

cash flow from P3)

Cash Flow without P4

(including higher cash

flow from P3)


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• Look for Incremental Benefits The trick in capital budgeting is to include all

the incremental cash flows from a proposed project.

Here are a some things to look out for:

1. Include all Indirect Effects

2. Forget Sunk Costs

3. Include Opportunity Costs

4. Recognize Investment in Working Capital

5. Beware of Allocated Overhead Costs


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1. Include all Indirect Effects To forecast incremental cash flows, trace out

all the indirect effects of accepting a project. For example:

Sometimes a project will hurt sales of an existing product.

Think of the Intel example we looked at. Sometimes a project will help sales of an existing

product. Adding a new route into an airport would increase

traffic, adding new revenues.


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Discount Incremental Cash Flows 2. Forget Sunk Costs

Sunk costs are like spilled milk: they are past and irreversible outflows!

The way to identify a sunk cost is to see if it remains the same whether or not you accept the project.

For example: Your firm paid $100,000 last year for a marketing report for a new widget it has developed. If you pursue the new widget project, the cash flow for the

marketing report is $100,000. If you do not pursue the new widget project, the cash flow for

the marketing report is $100,000.This is a sunk cost … it remains the same whether or not

you accept the project.


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Discount Incremental Cash Flows 3. Include Opportunity Costs

Most resources are not free, even if no money changes hands. Suppose your firm is considering building a factory on some land. Your firm purchased this land for $50,000. Its market value today is $100,000.

If your firm builds the factory, there is no out-of-pocket cost for the land. However, there is an opportunity cost.

That is the value of the foregone alternative use of the land. It could be sold for $100,000.

If we build the factory, we give up $100,000. Thus the opportunity cost equals the cash that could be realized from selling

the land now. This is the relevant cash flow for the project evaluation.

Notice that the purchase price of the land is irrelevant to analyzing the project-that cost is sunk.


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Discount Incremental Cash Flows 4. Recognize Investments in Working Capital

Net working capital is the difference between a firm’s short-term assets and liabilities. ST assets include Cash, Accounts Receivable and Inventories. ST liabilities include accounts payable, notes payable, and accruals.

Most projects entail an additional investment in working capital. Investments in working capital, just like investments in plant and

equipment, result in cash outflows. At the end of the project, when inventories are sold and accounts

receivable are collected, the firm has a cash inflow. Working capital is one of the most common sources of confusion in

forecasting project cash flows. Here are the most common mistakes: Forgetting working capital entirely. Forgetting that working capital may change during the life of the project.

Cash holdings, A/R and inventories will fluctuate over the life of the project. Forgetting that working capital is recovered at the end of the project


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Discount Incremental Cash Flows5. Beware of Allocated Overhead Costs

Accountants will allocate costs, such as rent, heat, or electricity to a firm’s operations. Allocated costs are not related to any particular project, but they

must be paid anyways. When analyzing a project for acceptance, include only the

extra expenses which would result from the project. If a project generates extra overhead costs, they should be

included in your analysis. However, if the firm would incur the overhead costs whether it

takes on the project or not, then those costs are not incremental. If they are not incremental, they should not be included in the

analysis.


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Discount Nominal Cash Flows by the Nominal Cost of Capital

Real cash flows must be discounted at a real discount rate. Nominal cash flows must be discounted at a nominal rate.

Mixing and matching nominal and real quantities, such as discounting real cash flows at a nominal rate, will lead to incorrect decisions.

As long as you are consistent in your treatment of the cash flows, you will get the same results whether you use nominal or real figures. (See Example 8.3)


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Separate Investment and Financing Decisions

• When analyzing a project, the first step is to determine whether it is worth undertaking. (I.e. positive NPV).

• If the project is worth undertaking, then you determine how to finance it.

• Even if a part of a the financing will come from debt, the interest and principal payments should not be recognized as cash outflows.

• Thus, when you calculate the cash flows from a project, ignore how the project is to be financed.

Analyze the project as though it were all equity financed, treating all the cash flows as coming and going to shareholders.

• If the project will benefit the shareholders, then you can conduct a separate analysis of the financing decision.


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Calculating Cash Flows• Total cash flows are the sum of 3 components:

1. Cash flow from investments in plant and equipment. Most projects need upfront capital investments in plant,

equipment, research, marketing etc. These expenditures are negative CFs. If the machinery is sold at the end, the proceeds will be a positive CF.

2. Cash flow from investment in working capital. Most projects require cash holdings, accounts receivable and

inventory. An increase in working capital implies a negative cash flow, a decrease implies a positive CF. The CF is measured by the change not the level of working capital.

3. Cash flow from operations. A firm invests in plant, equipment and working capital in the

expectation that they will generate operating cash flows.


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Calculating Cash Flow• Cash flow from operations (CFO)


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Calculating Cash Flow•Cash flow from operations (CFO)

Given the Income Statement below, calculate the cash flow from operations using the 3 methods:

Cash Revenues $1,000- Cash Expenses 600- Depreciation Expense 200= Profit before Tax 200- Tax @ 35% 70= Net Income 130


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Calculating Cash Flow• Cash flow from operations (CFO)

Cash Revenues – Cash Expenses – Taxes Paid

Net Profit + Depreciation = $130 + 200 = $ 330

(Cash Revenues – Cash Expenses) x (1- tax rate) + (depreciation x tax rate)

Method 1

Method 2

Method 3

= 1,000 - 600 - 70 = $ 330

= ($1,000 - 600) x (1- 0.35) + (200 x .35) = $ 330


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Business Taxes in Canada and the Capital Budgeting Decision

So far, we have calculated taxable income by deducting depreciation: Taxable Income = Revenues - Expenses - Depreciation

However, in Canada, taxable income is based on a deduction called Capital Cost Allowance (CCA), not on depreciation:

Taxable Income = Revenues - Expenses - CCA Although both are forms of amortization, they are not necessarily

calculated the same way. The depreciation a company reports on its income statement is

generally calculated in a different manner from the CCA it reports to Canada Revenue Agency.

Depreciation cannot affect a company’s cash flows – it is only a book entry.

The CCA amount has an effect on cash flows by reducing actual taxes payable.

Thus you must substitute CCA for depreciation in your calculations of the cash flows from a project.


8 - 238 - 23Business Taxes in Canada and the Capital

Budgeting Decision• Capital Cost Allowance (CCA)

The amount of write-off on depreciable assets allowed by Canada Revenue Agency against taxable income. It is calculated by multiplying UCC by the appropriate CCA rate. The

CCA rate is assigned according to an asset class system (see Table 8.1 on page 252)

Most asset classes use a declining balance method for computing CCA: apply the CCA rate to the balance for each year.

The half-year rule consists in adding only one-half of the purchase cost of the asset to the asset class and use it to compute CCA in the year of purchase. The remaining half of the cost will be added to the class next year.

• Undepreciated Capital Cost The balance remaining in an asset class that has not yet been

depreciated in that year.• CCA Tax Shield: Tax savings arising from the CCA charge.


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PV of CCA Tax ShieldsTo properly calculate the NPV of a project we must

calculate the PV of the OCFs separately from the PV of the CCA tax shield.

Because a project has a finite life while The CCA tax shield may have an infinite life. An asset can continue to generate CCA tax shields

for the firm even after it is sold. So CCA tax shield from investing in an asset can

continue in perpetuity.


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Present Value of CCA Tax Shields


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Present Value of CCA Tax Shields

Example:8.9 on page 256

55,954 - 763 = 55,191


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Present Value of CCA Tax ShieldsExample 8.9, page 256


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Example: Blooper Industries


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Semih Yildirim ADMS 3530 8 - 1 Chapter 8 Using Discounted Cash Flow Analysis Chapter Outline Discount Cash Flows, Not Profits Discount Incremental