Business Finance - Management Homework: NPV Assignment
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LectureNoteChapter9-UsingDiscountedCashFlowAnalysistoMakeInvestmentDecisions.docxBUSI 530
Chapter 9: Using Discounted Cash-Flow Analysis to Make Investment Decisions
Chapter 9 Learning Objectives
1. Identify the cash flows properly attributable to a proposed new project.
2. Calculate the cash flows of a project from standard financial statements.
3. Understand how the company’s tax bill is affected by depreciation and how this affects project value.
4. Understand how changes in working capital affect project cash flows.
Cash Flows
Chapter 8 introduced valuation techniques based on discounted cash flows.
This chapter develops criteria for properly identifying and calculating cash flows.
Chapter 9 Outline
· Identifying Cash Flows
· Discount Cash Flows, Not Profits
· Discount Incremental Cash Flows
· Discount Nominal Cash Flows by the Nominal Cost of Capitol
· Separate Investment & Financing Decisions
· Calculating Cash Flows
· Example: Blooper Industries
Identifying Cash Flows: Cash Flow vs. Accounting Income
Discount actual cash flows, not necessarily net income.
Using accounting income, rather than cash flow, could lead to erroneous decisions.
NPV: Accounting Income
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 flows to the NPV using accounting income.
NVP: Cash Flows
Example (ctd)
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 flows to the NPV using accounting income.
Which is correct?
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
· Remember Shutdown Cash Flows
Incremental Cash Flow
Cash Flow with Project
Cash Flow without Project
=
-
Incremental Cash Flow – The extra cash flows produced by a project.
Inflation and Discounting Cash Flows
Discounting Rule: Real cash flows must be discounted at a real discount rate, nominal cash flows at a nominal rate.
Inflation – rising price levels
Inflation Example: Nominal Rates
Example
You own a lease that will earn you $8,000 next year, increasing at 3% a year for 3 additional years (4 years total). If discount rates are 10% what is the present value of the lease?
Inflation Example: Real Rates
Example (ctd)
You own a lease that will earn you $8,000 next year, increasing at 3% a year for 3 additional years (4 years total). If discount rates are 10%, what is the present value of the lease?
Include all Indirect Effects
Indirect Effect Rule: You must include all indirect effects in your analysis.
Sunk Costs
· A cost that cannot be recovered
Sunk Cost Rule: Always ignore sunk costs
Opportunity Cost
· Benefit or cash flow foregone as a result of an action
Opportunity Cost Rule: Be sure to recognize the opportunity cost (that which is foregone).
Investments in Working Capital
Working Capital Rule: Investments in working capital, just like investments in plant and equipment, result in cash outflows.
Common ways working capital is overlooked:
1. Forgetting about working capital entirely.
2. Forgetting that working capital may change during the life of the project.
3. Forgetting that working capital is recovered at the end of the project.
Net Working Capital – Current assets minus current liabilities
Additional Considerations
1. Remember Terminal Cash Flows
2. Beware of Allocated Overhead Costs
3. Separation of Investment & Financing Decisions
Final Thought: Incremental Cash Flows
Ask the following 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.
Calculating Cash Flows
Cash flows are made up of three separate parts.
Total cash flow =
+ cash flows from capital investments
+ cash flows from changes in working capital
+ operating cash flows
Calculating Cash Flows
Capital Investments
Changes in Working Capital
Operating Cash Flows Operating cash flow = Revenue – Costs – Taxes
Cash Flow from operations: Three Methods of Calculation
· Method 1: Dollars in Minus Dollars Out
· Method 2: Adjusted Accounting Profits
· Method 3: Tax Shields
Depreciation Tax Shield – Reduction in taxes attributable to depreciation.
Calculating Cash Flow: Example
|
|
Year 0 |
Year 1 |
Year 2 |
Year 3 |
Year 4 |
|
Fixed Assets |
|
|
|
|
|
|
Purchase of Factory (sale in 4 years) |
-$100,000 |
$ 0 |
$ 0 |
$ 0 |
$ 50,000 |
|
Total Cash Flow from Fixed Assets |
-$100,000 |
$ 0 |
$ 0 |
$ 0 |
$ 50,000 |
|
|
|||||
|
Working Capital |
|
|
|
|
|
|
CF from Inventory (- buildup,+ sell off) |
$ 0 |
-$ 20,000 |
-$ 10,000 |
$ 10,000 |
$ 20,000 |
|
CF from Accounts Receivable |
$ 0 |
-$ 35,000 |
-$ 25,000 |
$ 30,000 |
$ 30,000 |
|
Total Cash Flow from Working Capital |
$ 0 |
-$ 55,000 |
-$ 35,000 |
$ 40,000 |
$ 50,000 |
|
|
|||||
|
Operations |
|
|
|
|
|
|
Revenues |
$ 0 |
$120,000 |
$125,000 |
$150,000 |
$150,000 |
|
Expenses |
$ 0 |
$ 60,000 |
$ 61,250 |
$ 70,000 |
$ 70,000 |
|
Depreciation |
$ 0 |
$ 12,500 |
$ 12,500 |
$ 12,500 |
$ 12,500 |
|
Pre-Tax Profits |
$ 0 |
$ 47,500 |
$ 51,250 |
$ 67,500 |
$ 67,500 |
|
After-Tax Profits (tax rate = 35%) |
$ 0 |
$ 30,875 |
$ 33,313 |
$ 43,875 |
$ 43,875 |
|
Total Cash Flow from Operations |
$ 0 |
$ 43,375 |
$ 45,813 |
$ 56,375 |
$ 56,375 |
|
|
|||||
|
Total Cash Flow |
-$100,000 |
-$11,625 |
$10,813 |
$ 96,375 |
$106,375 |
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