Chapter 9

Using Discounted Cash-Flow Analysis

to Make Investment Decision

Financial Management (MGCM10018)

Preview
• Chapter 8 introduced valuation techniques
based on discounted cash flows.
• This chapter develops criteria for properly
identifying and calculating cash flows.

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Outline
• Identifying Cash Flows
• Calculating Cash Flow
• An Example: Blooper Industries

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Identifying Cash Flows (9.1)

• Cash flows vs. accounting income

▫ Discount actual cash flows, not necessarily net
income.
▫ Using accounting income, rather than cash flow,
could lead to erroneous decisions.
• Recall from chapter 3, income statements are
intended to show how well the firm has
performed, not to track cash flows.

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Identifying Cash Flows (continued)

• If the firm lays out a large amount of money on a

big capital project.
▫ We should not say that the firm performed poorly
that year, even though a lot of cash is going out.
▫ Thus, the accountant does not deduct capital
expenditure when calculating income.
▫ Instead, we depreciate it over several years.
• This is fine for computing annual profits, but it
could get you into trouble when finding NPV.
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 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.
Year 1 Year 2
Cash Inflow $1,500 $ 500
Depreciation -$1,000 -$1,000
Accounting Income +$ 500 - $ 500

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 Example

The NPV using cash flows:

Today Year 1 Year 2
Cash Inflow $1,500 $ 500
Project Cost -$2,000
Free Cash Flow -$2,000 +$1,500 + $500

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Identifying Cash Flows (continued)

• There is no doubt that we should use the cash

NPV in the previous example.
• When calculating NPV, recognize investment
expenditures when they occur, not later when
they show up as depreciation.
• The focus of capital budgeting must be on cash
flow, not profits.

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Incremental Cash Flows
• A project’s present value depends on the extra
cash flows that it produces.
▫ First, we need to forecast the firm’s cash flows if
we go ahead with the project.
▫ Second, forecast the cash flows if we don’t accept
the project.
▫ The difference is the incremental cash flows.

Incremental Cash Flow Cash Flow

Cash Flow = with Project - without Project
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Incremental Cash Flows
• We need to trace all the incremental cash flows
from a proposed project in capital budgeting.
• There are some things to look out for:
▫ 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

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Include All Indirect Effects
• New products often damage sales of existing
product.
▫ Take iPhone as a good example.
• A new project may help the firm’s existing
business.
▫ New air route from a small town itself may have
negative NPV but add customers in existing traffic.
• We must include all indirect effects in the
analysis.
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Forget Sunk Costs
• Recall that sunk cost is a retrospective cost that
has already been incurred and cannot be
recovered.
▫ Sunk costs remain the same whether or not we
accept the project.
▫ Thus, they do not affect project NPV.
▫ Example: Lockheed’s Tristar airplane.
• We always ignore sunk costs when calculating
incremental cash flows.
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Include Opportunity Costs
• Opportunity cost: benefit or cash flow foregone
as a result of an action.
▫ A new manufacturing operation uses a land that
could otherwise be sold for $100,000.
▫ This $100,000 should be included as the cost of
new project.
▫ The original cost of purchasing the land is
irrelevant – that cost is sunk.

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Investment in Working Capital
• The net working capital is the difference between
a company’s short-term assets and its liabilities.
▫ Current assets: cash, accounts receivable,
inventories...etc.
▫ Current liabilities: accounts payable, notes
payable, accruals...etc.
• Most projects entail an additional investment in
working capital.

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Investment in Working Capital
• For example, a new production may require
more inventories of raw materials, and the
customers may be slow to pay.
▫ This increases current assets.
▫ Thus, investments in working capital, just like
investments in plant and equipment, result in
increase in cash outflows.

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Investment in Working Capital
• Common ways working capital is overlooked:
▫ Forgetting about working capital entirely.
▫ Forgetting that working capital may change
during the life of the project.
▫ Forgetting that working capital is recovered at the
end of the project.

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Terminal Cash Flows
• The end of project almost always brings
additional cash flows.
▫ We might be able to sell some of the plant,
equipment, or real estate that was dedicated to the
project.
▫ We may also recover some of working capital
when collect the outstanding receivable.

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Allocated Overhead Costs
• Accountants must assign costs of a firm to its
projects.
• Some overhead costs such as rent or electricity
may or may not belong to a project.
• We should be cautious about accountants’
allocation of overhead cost.
• Include only the extra expenses of the project.

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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.

1+nominal interest rate

1 + real interest rate = 1+inflation rate

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Inflation Example: Nominal Rates
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?

Year Cash Flow PV @ 10%

0 $ 8,000 $8, 000
1
1 $ 8,000 x 1.03 = $ 8,240 8240
1.101
= $ 7, 491
2 $ 8,000 x 1.032 = $ 8, 487 8487
1.102
= $ 7,014
3 $ 8,000 x 1.033 = $ 8,742 8742
1.103
= $ 6,568
$29,073
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Inflation Example: Real Rates

Year Cash Flow PV @ 6.80%

0 $ 8,000 $ 8, 000
8,000
1 $ 8,000 1.0681
= $ 7, 491
8,000
2 $ 8,000 1.0682
= $ 7,014
8,000
3 $ 8,000 1.0683
= $ 6,568
$29,073

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Investment and Financing Decisions
• Suppose we finance a project partly with debt.
▫ Should we subtract the debt proceeds from the
required investment?
▫ Should we recognize the interest and principal
payments on the debt as cash outflows?
▫ No, these are decisions on financial actions.
• We should view the project as if it were all
equity-financed.

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Final Thoughts
• 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.

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Calculating Cash Flow (9.2)

• Cash flows are made up of three separate parts:

Total cash flow =

cash flows from capital investments
+ operating cash flows
+ cash flows from changes in working capital

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Capital Investment
• To get a project started, a company typically
needs to make up-front investments in plant,
equipment, research, marketing, and so on.
▫ For example, development of a new car model
typically involves expenditure of $500 million or
more.

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Operating Cash Flow
• In the new car model example, operating cash
flow consists of revenues from sale of the new
product less the cost of production and any taxes.

Operating cash flow = Revenue – Costs – Taxes

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Operating Cash Flow
• When firm calculates its taxable income, it
makes a deduction for depreciation.
▫ The depreciation charge is not a cash expense but
affects the tax that the firm pays.
• There are three ways to deal with depreciation:
• Model 1: Dollars in Minus Dollars Out
▫ Take only the items from the income statement
that represent actual cash flows.
Operating Cash Flow = Revenue - Cash Expenses - Taxes
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 Operating Cash Flow
• Model 2: Adjusted Accounting Profits
▫ Start with after-tax accounting profits and add
back any depreciation deduction.
Operating Cash Flow (OCF) = After-tax Profit + Depreciation

• Model 3: Add Back Depreciation Tax Shield

▫ Depreciation tax shield: reduction in taxes
attributed to depreciation.
OCF = (Revenue − Cash Expenses) × (1 − Tax Rate)+(Tax Rate × Depreciation)

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Changes in Working Capital
• Investment in working capital such as in
inventories of raw materials or in accounts
receivable represents negative cash flows.
• Later in the life of a project, when the
inventories are sold and receivable are collected,
positive cash flows occur.

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Example: Blooper Industries (9.3)

• Suppose we are the financial managers of

Blooper Industries to analyze a proposal for
mining and selling a small deposit of high-grade
magnoosium ore.
• We are given the forecasts shown in the
following table.

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Example: Blooper Industries (continued)

• Panel A summarizes the assumptions.

• Panel B details investments and disinvestments in
fixed assets.
▫ The project requires an initial investment of $10
million.
▫ After 5 years, the mining equipment may be sold for
$2 million.
 We assume that the firm depreciates the equipment to
final value of zero.
 Thus, the $2 million sale would be treated as taxable gain,
and with 35% tax, the net cash flow become $1.3 million.
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Example: Blooper Industries (continued)

• Panel C shows changes in operating cash flow.

▫ The firm expects to sell 750,000 pounds of
magnoosium a year at $20 per pound.
 This leads to $15 million revenue.
 Row 19 shows revenues rising each year in line with
inflation of 5%.
 Annual expense is $10 million, this also need to
consider impact of inflation (row 20).
 Using straight-line depreciation to deduct the 1/5 of
initial $10 million from profits.
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35
Example: Blooper Industries (continued)

• Panel C shows changes in operating cash flow.

▫ Row 22 shows pretax profit as (revenues – expenses -
depreciation).
▫ Row 23 shows taxes as 35% of pretax profit.
▫ Row 24 shows profit after tax.
▫ Row 25 shows cash flows as sum of after-tax profits
and depreciation.
• Panel D shows changes in working capital.
▫ Row 28 shows the level, and row 29 shows changes.
▫ Row 30 shows cash flows as negative of changes.
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Example: Blooper Industries (continued)

• Panel E presents the project valuation.

▫ Row 33 shows total project cash flows as sum of 3
sources (rows 16, 25, and 30).
▫ Discount each year’s cash flows to row 35 with
12% opportunity cost.
▫ Row 36 shows the NPV of $4.2 million as sum of
row 35.

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Example: Blooper Industries (continued)

• Forecasting working capital.

▫ Consider the revenue of $15,000 in year 1.
 Suppose that the customers pay with 2-month lag in
average, the account receivable would be 2/12 of
each year’s sales.
 That would be (2/12)*15,000 = $2,500 for year 1.
▫ Consider the expense of $10,000 in year 1.
 Assume 15% of expense represent an investment in
inventory that took place in previous year.
 So the inventory of year 0 would be 0.15*10,000 =
$1,500. 38
Example: Blooper Industries (continued)

• Forecasting working capital.

▫ This is the level of working capital reported in row

28 in the spreadsheet.

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Example: Blooper Industries (continued)

• Note on depreciation.
▫ Here the firm depreciates the investment in
mining equipment by $2 million a year.
 This produces an annual tax shield of $0.7 million
for 5 years.
 These tax shields increase cash flows and present
values.
 If they can be obtained sooner, they would be worth
more.
▫ The modified accelerated cost recovery system
(MACRS) is permitted by tax law.
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How does MACRS depreciation affect the
value of depreciation tax shield?

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Example: Blooper Industries (continued)

• All large corporations in the U.S. keep two sets

of books, one for stockholders and one for the
Internal Revenue Service (IRS).
▫ It is common to use straight-line depreciation on
the shareholder books and MACRS depreciation
on the tax books.
• Only the tax books are relevant in capital
budgeting.

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