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09DCFAnalysis.pptxTopic 9 DCF Analysis
Fundamentals of Finance
Fall 2017
Zhun Liu
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Review and Outline
We learned capital budgeting techniques
NPV: Always right
Payback: Takes into account liquidity
IRR: Intuitive
This class we will focus on how to compute the project cash flows
This is the basis of discounted cash flow (DCF) valuation
What are incremental cash flows?
How to compute project cash flows?
Examples
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Incremental cash flows
The incremental cash flows for project evaluation consist of any and all changes in the firm’s future cash flows that are a direct consequence of taking the project
Relevant cash flows = incremental cash flows
Incremental cash flows = CF w/ project – CF without
These are the right cash flows to consider to evaluate our project!
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Asking the Right Question
You should always ask yourself “Will this cash flow occur ONLY if we accept the project?”
If the answer is “yes”, it should be included in the analysis because it is incremental
If the answer is “no”, it should not be included in the analysis because it will occur anyway
If the answer is “part of it”, then we should include the part that occurs because of the project
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Common Types of Cash Flows
Sunk costs
Fixed Overhead Expenses
Past Research and Development
Opportunity costs
Side effects
Erosion/Cannibalization
Spillover
Net working capital
Financing costs
Taxes
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Sunk Costs
A cost that is already paid and cannot be recovered
Examples:
You buy an expensive book but after only 10 pages you realize that it is really boring. Do you still want to finish the book?
Oil / Mining exploration activities
R&D
Advertising
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Opportunity Costs
Cost of lost options
Examples:
Renovating projects: You may want to think about what happens if you do not renovate
Forgone income: When analyzing education investments
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Example: What Are Relevant Costs
Three years ago, the Jamestown Co. purchased some land for $1.24 million. Today, the land is valued at $1.32 million. Six years ago, the company purchased some equipment for $189,000. This equipment has a current book value of zero and a current market value of $39,900.
What value should be assigned to the land and the equipment if the Jamestown Co. opts to use both for a new project?
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Side Effects
Erosion
A negative impact on the cash flows of an existing product from the introduction of a new product
If another firm would (or could) produce this new product in any case, then any sales erosion should be ignored
Spillover
A positive impact on the cash flows of an existing product from the introduction of a new product
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Example: Relevant Cash Flows under Side Effects
The Blue Shoe currently sells 13,000 pairs of athletic shoes and 4,500 pairs of dress shoes every year. The athletic shoes sell for an average price of $79 a pair while the average price for the dress shoes is $49. The company is considering expanding their offerings to include sandals at an average price of $29 a pair. The Blue Shoe estimates that the addition of sandals to their lineup will reduce their dress shoe sales by 1,000 pairs and increase their athletic shoes sales by 800 pairs. The Blue Shoe expects to sell 4,500 pairs of sandals if they decide to carry them.
What amount should the Blue Shoe use as the annual estimated sales revenue when they analyze the addition of sandals to their lineup?
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Example: Relevant Cash Flows under Side Effects
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Taxes
Taxes affect project cash flows
Be careful, taxes are always changing
Marginal vs. average tax rates
Marginal tax rate – the percentage paid on the next dollar earned
Average tax rate – the tax bill / taxable income
We will usually assume a marginal tax rate around 35%
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Depreciation
The depreciation expense used for capital budgeting should be the depreciation schedule required by the IRS for tax purposes
Depreciation itself is a non-cash expense; consequently, it is only relevant because it affects taxes
Depreciation tax shield = D∙T
D = depreciation expense
T = marginal tax rate
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DUE to TAX
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Computing Depreciation
Straight-line depreciation
D = (Initial cost – salvage) / number of years
Very few assets are depreciated straight-line for tax purposes
* Modified Accelerated Cost Recovery System (MACRS)
Same idea, different depreciation schedule
We will use straight line depreciation
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The MACRS percentages are given in Table 10.7 on page 313.
Net Working Capital
Investment needed to start operations
Cash on hand to pay any expense that may arise directly from operations
Initial investment in inventories
Accounts receivables to cover credit sales
Accounts payable to pay for credit purchases
Working capital is always recovered at the end of the project for finite lived projects
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More on NWC
Why do we have to consider changes in NWC separately?
Timing issue: GAAP requires that sales be recorded on the income statement when made, not when cash is received
GAAP also requires that we record cost of goods sold when the corresponding sales are made, whether we have actually paid our suppliers or not
Finally, we have to buy inventory to support sales although we haven’t collected cash yet
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Change in Net Working Capital
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DNWC = D Inventory
+ D Accounts Receivable
– D Accounts Payable
D X = X Current period – X Previous period
Net working capital
The Fritz Co. is considering a new project and asked the chief accountant to review potential changes to the net working capital accounts should the project be adopted. The accountant’s report is as follows:
Current Projected
Inventory $ 99,218 $ 75,000
Accounts receivable $ 89,430 $ 110,000
Accounts payable $ 58,640 $ 50,000
What amount should be included in the initial cash flow of the project for net working capital?
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Net working capital
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Current Projected Cash Flow
Inventory $ 99,218 $ 75,000 – $24,218
Accounts receivable $ 89,430 $110,000 $20,570
Accounts payable $ 58,640 $ 50,000 – $ 8,640
DNWC $ 4,992
DNWC = DInventory + DAccounts Receivable – DAccounts Payable
= – $24,218 + $20,570 – (– $ 8,640)
= $ 4,992
After-Tax Salvage
If the salvage value is different from the book value of the asset, then there is a tax effect – you escaped taxes by over-reporting depreciation, and you have to turn it back to IRS
Book Value = Initial Cost – Accumulated Depreciation
After-Tax Salvage = Salvage – Tax*(Salvage – Book Value)
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Example: Depreciation and After-tax Salvage
You purchase equipment for $100,000 that is depreciated straight-line to 0 in 10 years.
Based on past information, you believe that you can sell the equipment for $50,000 when you are done with it in 6 years.
The company’s marginal tax rate is 40%.
What is the depreciation expense each year, and the after-tax salvage in year 6?
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Example: Straight-line Depreciation
Depreciation = 100,000 / 10
= 10,000 every year
Book Value in year 6 = 100,000 – 6 x (10,000)
= 40,000
After-tax salvage = 50,000 – 0.4 x (50,000 - 40,000)
= 46,000
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Project Cash Flows
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EBIT
Operating CF (OCF)
Net Income
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Example: Net Income from Income Statement
A project is expected to generate $48,400 in sales, $31,500 in costs and $7,500 in depreciation expense.
What is the projected net income for this project if the applicable tax rate is 34%?
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Sales $48,400
Costs 31,500
Depreciation 7,500
EBIT $ 9,400
Tax (34%) 3,196
Net income $ 6,204
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Example: Net Income from Income Statement
Operating Cash Flow
Betty’s Boutique is considering a project with projected sales of $46,000. Costs are estimated at $29,500. The project will require $20,000 initially for the purchase of new equipment. This equipment will be depreciated using straight line depreciation to a zero book value over the four year life of the project. The equipment will be worthless at the end of the four years. The tax rate is 35%.
What is the amount of the projected annual operating cash flow for this project?
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Operating Cash Flow
Sales $46,000
Costs 29,500
Depreciation 5,000 ($20,000 4)
EBIT $11,500
Tax (35%) 4,025
Net income $ 7,475
OCF = EBIT– Taxes + Depreciation
OCF = $11,500 + $5,000 – $4,025 = $12,475
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Finally, together with what we’ve learnt from last class, NPV Calculation
Wilson’s is considering a project which will initially require $12,000 for new equipment. The equipment will be depreciated straight line to a zero book value over the three year life of the project. In addition, the project will require $30,000 of net working capital which will be recovered at the end of the project.
Annual sales are estimated at $45,000 with costs of $32,400. The equipment has an expected salvage value of $1, 200. The tax rate is 34%.
What is the net present value of this project if the required rate of return is 14%?
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NPV Example
Initial cash flow = – $12,000 – $30,000 = – $42,000
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Appendix: Financial Statements
Why do we need to understand financial statements in capital budgeting?
Briefly, because we need to pay taxes
We need to compute after tax cash flows (Free Cash Flow)
Taxes are computed in the Income Statement (I/S)
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Appendix: Income Statement for DCF
Is Net Income = Cash Flow?
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Sales
– Cost of Goods Sold (COGS)
– Depreciation
EBIT
– Tax
Net Income
Appendix: Pro Forma Financial Statements
We forecast financial statements using estimates of:
Sales
Selling price per unit
Variable cost per unit
Total fixed costs
Net working capital
Investments
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$144,700
Total
$130,500
$29
4,500
Sandals
49,000
$
-
$49
1,000
-
shoes
Dress
63,200
$
$79
800
shoes
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