PowerPoint PresentationTopics CoveredCash Flow vs. Accounting IncomeSlide 4Slide 5Incremental Cash FlowsSlide 7InflationSlide 9Slide 10Slide 11Separation of Investment & Financing DecisionsBlooper IndustriesSlide 14Slide 15Chapter 8Fundamentals of Corporate FinanceFifth EditionSlides byMatthew WillMcGraw-Hill/IrwinCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Using Discounted Cash Flow Analysis to Make Investment DecisionsCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 2Topics CoveredIdentifying Cash FlowsDiscounted Cash Flows, Not ProfitsIncremental Cash FlowsTreatment of InflationSeparate Investment & Financing DecisionsCalculating Cash FlowsExample: Blooper IndustriesCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 3Cash Flow vs. Accounting IncomeDiscount actual cash flowsUsing accounting income, rather than cash flow, could lead to erroneous decisions.ExampleA 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.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 4Year 1 Year 2Cash Income $1500 $ 500Depreciation -$1000 -$1000Accounting Income + 500 - 50032.41$)10.1(5001.10500=NPVApparent 2Cash Flow vs. Accounting IncomeCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 5Today Year 1 Year 2Cash Income $1500 $ 500Project Cost - 2000 Free Cash Flow - 2000 +1500 + 500Cash NPV =- 20001.10  1500110500110142 3( . ) ( . )$223.Cash Flow vs. Accounting IncomeCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 6Incremental 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 CostsIncremental Cash Flowcash flow with projectcash flow without project=-Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 7Incremental Cash FlowsIMPORTANTIMPORTANTAsk yourself this questionWould the cash flow still exist if the project does not exist?If yes, do not include it in your analysis.If no, include it.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 8InflationINFLATION RULEINFLATION 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 figuresCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 9InflationExampleYou 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  real interest rate =1+nominal interest rate1+inflation rateCopyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 10InflationExample - nominal figures$29,072.98 6,567.868,741.82=8000x1.0337,014.2220.487,8=8000x1.03291.490,78,240=8000x1.03100.000,88000010% @ PVFlowCash Year3210.182.8741310.120.8487210.18240Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 11InflationExample - real figures29,072.98 6,567.868,00037,014.228,00027,490.918,00018,0008,[email protected]%FlowCash Year32068.18,000068.18,000068.18,000= $Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 12Separation 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.Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 13Blooper IndustriesYear 0 1 2 3 4 5 6Cap InvestWCChange in WCRevenuesExpensesDepreciationPretax Profit.Tax (35%)Profit10 0001 500 4 075 4 279 4 493 4 717 3 039 01 500 2 575 204 214 225 1 678 3 03915 000 15 750 16 538 17 364 18 23310 000 10 500 11 025 11 576 12 1552 000 2 000 2 000 2 000 2 0003 000 3 250 3 513 3 788 4 0781 050 1137 1 230 1 326 1 4271 950 2 113 2,, , , , , ,, , , ,, , , , ,, , , , ,, , , , ,, , , , ,, , , , ,, , , , ,283 2 462 2 651(,000s)Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 14Blooper IndustriesCash Flow From Operations (,000s)Revenues- ExpensesDepreciation= Profit before tax.-Tax @ 35 %= Net profit+ Depreciation= CF from operations15 00010 0002 0003 0001 0501 9502 0003 950,,,,,,,,or $3,950,000Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin8- 15Blooper IndustriesNet Cash Flow (entire project) (,000s)4,3396,3294,2374,0693,9091,37511,500-FlowCash Net 4,6514,4624,2834,1133,950Op from CF039,31,678225-214-204-2,575-1,500-in WC Change300,110,000- valueSalvageInvest Cap6543210Year NPV @ 12% =