Lecture 5
Project Analysis
Discounted Cash Flow Analysis
Managerial Finance
FINA 6335
Ronald F. Singer
Capital Budgeting Decisions
Check List
1- Net Present Value is the "Discounted value of cash flow"
2- Cash flow is:
cash money in - cash money out,
3- Consider only if it is an incremental cash flow, and consider
all incremental cash flows:
(a) not historical, or averages:
(b) consider only cash flows that appear as a result of the
project:
4- Treat inflation consistently:
(a) Discount real cash flow by real discount rates
(b) Discount nominal cash flows by nominal discount rates
Note: Revenues and costs will not necessarily react uniformly
to inflation.
5-2
Capital Budgeting Decisions
Check List
5- All Cash Flow should be on an After-Tax basis.
6- Don't forget to allow for the tax on capital gains
7- Account for assets sold and not sold as a result of adoption
of a project.
8- Account for changes in working capital and only changes in
working capital.
9- Ignore financing
10- Use actual tax changes when paid!
11- No matter how complicated the decision:
What is
important?
MAXIMIZE NPV
Plan to take all projects with a Positive Net Present Value and
reject all projects with a Negative Net Present Value
5-3
Discounted Cash Flow Analysis

Cash Flow Checklist
1- Clarify all assumptions
2- Indicate the effect of the product being
considered on other products of the firm.
3- Exclude sunk costs (excess capacity?)
4- Include opportunity costs for any factor of
production even if there is not an explicit cash
outlay.
5- Exclude allocated overheads that do not change,
but include overheads that will change as a result
of adoption of the project.
5-4
6- Insure that the tax rate used reflects future
marginal tax effects
7- Exclude all financing flows including the tax
shield of interest
8- Include Net Working Capital Changes:
9- Include Asset's Entire Life:
10- Include the depreciation tax shield, but not
depreciation itself.
5-5
What is guano ?
"But, I would much rather bet on instinct than
a random DCF model“
A Vice President Finance

The Development of DCF:
1.Irving Fisher, 1930: First introduced DCF formulas to
academics
2.Lutz & Lutz, 1951: Define IRR
3.Hirschleifer, 1958: Demonstrates superiority of NPV
vs. IRR

In Practice
1966: 47% of responding firms (Fortune) use DCF
whereas only 9% used DCF in 1955.
1978: of 424 large corps: 86% use DCF
5-6
Application of the NPV Rule and
Capital Budgeting
We are going to assume that the appropriate interest rate is
known. The problem we want to tackle is to Forecast the
relevant cash flows.
 Rule 1: Only Cash flows affect wealth. Since data comes
from accounting statements we must "adjust" the income
statement to obtain the cash flow.
 Rule 2: Only incremental cash flows are relevant, not
historical cash flows, not averages, not sunk costs.
 Rule 3: Treat inflation consistently.
 Rule 4: Tying up assets uses a valuable resource and must
be accounted for.
 Rule 5: Remember the impact of non-cash expenses on
tax liabilities.
 Rule 6: Ignore the means of financing both as a direct cash
5-7
flow and as its effect on taxes.
Rule 1: Only Cash flows affect wealth. Since data
comes from accounting statements we must
"adjust" the income statement to obtain the cash
flow.

Net Cash Flow = Dollars in - Dollars out
What is and is not Cash Flow
-Depreciation is not a cash flow
-Taxes are cash flow when paid
-Accounts receivable, becomes a cash flow
when the money actually changes hand
-When you build up inventory you have no
cash inflow, when you sell from the inventory
(and get paid) you have a cash inflow.
-Expenses are cash flow regardless of whether
the accountant capitalizes and depreciates them
or expenses them.
-Capital expenditures are cash outflows
regardless of the fact that accountants
depreciate them over a period.
5-8
Rule 2: Only Incremental cash flows are
relevant, not historical cash flows, not
averages, not sunk costs!
Example 1: Consider a firm having made an investment one
year in the past. The project required an initial investment
of $10,000, with the expectation of $14,000 to be generated
within two years. At a discount rate of 10% should the firm
have made the investment?
14,000
-1
0
1
10,000
Of course it should have. The NPV was:
NPV = 1,564
5-9
But now assume that things have changed. an
expected new device introduced by a competitor
has made the product obsolete. as a result
expected cash flows has declined from $14,000 to
$7,000. clearly, the investment, in retrospect did
not pay off as expected and the project is now a
loser.
However, suppose that for an additional investment
of $5,000, you can regain your competitive
position, so that expected cash flow will increase
to the original $14,000. should you make the new
5-10
investment?
14,000
-1
0
5000
1
10,000
Note that the project, looked at as a whole is still a
loser:
NPV(-1) = -10,000 - 5,000 + 14,000
(1.1)
(1.1)2
= - 2,975
5-11
BUT the additional investment should be made. The
incremental cash flows looks like:
7,000
-5,000
The Net Present Value from the incremental cash
flow is:
And this has a NPV of:
5-12
Example 2: Assume that the original cash flow estimates were
accurate. But, that you can, by making an additional
investment of 1,000 generate total second period cash flow of
15,050. Should the additional investment be made?
(Still Assume r= 10%)
14,000
-1
-10,000
-1
0
1
15,050
0
-1,000
Initial
With
Additional
1
Investment
-10,000
NPV (of Additional Investment) = -1000 + 1050 = -45.45
1.1
Even though, the original project is a winner, do not make the
additional investment
Rule 2 says Ignore Sunk Costs, and consider only
5-13
incremental cash flows.
Rule 3: Treat inflation consistently
Make sure that inflation is accounted for in a
consistent manner. either:
1. State cash flows in terms of actual dollars, at the
time the cash flows are received. These are
nominal cash flows. Or,
2. State the cash flows in terms of current dollars,
at the time the projections are made. These are
real cash flows.
If cash flows are in nominal terms, then use nominal
discount rates to discount the cash flows.
If cash flows are in real terms then use real discount
rates to discount the cash flows.
5-14
Example: There is 8% anticipated inflation per year.
The real price of Honda Accords is expected to
remain constant into the foreseeable future at
$14,000. What will the nominal price be after 5
years?
Nominal Price = (Real Price) (1.08)5
= (14,000) x FUTURE VALUE(8%, 5)
= $20,566
5-15
In general terms:
Converting nominal cash flows to real cash flows, and
nominal interest rates to real interest rates.
If Y(t) is the nominal cash flow in period t, in is the annual
anticipated inflation rate, then the real cash flow, y(t) is:
y(t) = Y(t)
and
Y(t) = y(t)(1+in)t
(1+in)t
if R is the annual nominal interest rate, and r is the real interest
rate, then:
(1+R) = (1+r)(1+in)
(1+r) = (1+R)/(1+in)
Don't assume that all cash flows will be affected equally by
inflation.
Beware of the Approximation:
R = r + in
5-16
This works only if r X in is small.
Rule 4: Tying up assets uses a valuable resource
and must be accounted for.
Example: A firm is considering installing a brick
manufacturing kiln. The initial investment will
require $300,000 in building and equipment. The
kiln will be located on a vacant lot having an
estimated market value of $1,000,000. The
project is expected to generate net cash flow of
$50,000 per year for 20 years. After 20 years, the
kiln will be worthless. It is anticipated that the lot
could be sold for $2,000,000 at the end of 20
years. At a 10% discount rate, is this a good
investment? (Ignore taxes)
5-17

The Wrong Way
Ignoring the opportunity cost of the (tied-up) land.
Net present value calculation
-300,000 + PMT(50,000, 10%, 20)
-300,000 + 425,693.05 = 125,693.05
Accept Project
The problem with this is that you ignore the fact that
you lose the use of $1,000,000 that you could have
had if you had not adopted the project and sold the
land (or used it in an alternative project).
5-18
The Right Way
Present Value Calculation
NPV = -1,000,000 -300,000 + PMT(50,000, 10%, 20)
+ PV($2,000,000,10%,20)
= - 1,300,000 + 425,693.05 + 297,287.96
= - 577019
Reject Project
Notice how the tied up land is treated!
5-19
Other Incremental Costs Are
Increases in overhead costs as a result of project.
Increases in working capital as a result of project.
Notice the reduction in working capital would be a
cash inflow at that time.
Do not use allocated overhead, or allocated working
capital.
Example: Suppose, due to the adoption of the
project, the firm is required to increase working
capital from $100,000 to $110,000 per annum for
the life of the project. How do you account for the
working capital?
5-20
Rule 5: Remember taxes and the effect of
non-cash expenses
1. Calculate all cash flows after taxes
2. Include non-cash expenses (depreciation) for its
effect on taxes, but not as a cash flow in and of
itself.

How to handle the Depreciation Tax Shield
we want the project's After Tax Cash Flow
Equals:
Before Tax Cash Flow Less Corporate Taxes
Taxes = tc [Cash revenue - Cash Expenses - Depreciation]
5-21
Therefore, for each year:
After Tax Cash Flow =
(Cash Revue - Cash Expenses)(1 - tc)+ tc Depreciation
Where: tc x Depreciation is the Depreciation Tax Shield
3. Tax on gains/losses from sale of assets is an
additional cash flow
Tax on
Gains/Losses = tc x (Market Value - Book Value)
On sale
If Market Value > Book Value, then tax on gain is cash
outflow.
If Market Value < Book Value, then we have a loss on
sale, tax is negative, and there is a cash inflow.
5-22
Example:
Rule 6: Ignore the means of financing both as a direct
cash flow and as its effect on taxes.
Interest payment is not a cash flow. Discounting already takes
the value of time into account. To deduct interest would be
double counting.
Example: Suppose that you borrow $500, and put in $500 of your
money into the following project. (Bank charges 8% on loan)
0
1
Cash Flow
-1000
1125
Interest
-40
Net
-1000
1085
To say that we reject the project since NPV (of net cash flow) is
negative at 10% (NPV = -13) is double counting. We penalize
the project twice, one by deducting interest, second by
discounting.
The NPV of this project is: - 1,000 + (1,125) X (0.909) = 23
5-23
Case Example: Netco Case
Project Analysis

Steps in project analysis
1. Make initial projections
– Made by operations manager
– Generally in form of income statement
– Clarify assumptions
2. Adjust for inflation if appropriate
3. Rearrange in cash flow form
4. Perform net present value calculations
5. Perform "what if" calculations
5-24
Project Analysis

Book Value
Total (long term plus short term) Assets less
Liabilities
For project analysis:
Cost of Long Term Assets
Less: Accumulated Depreciation
Plus: Working Capital
5-25
Project Analysis

Profit
Total Sales
Less: Cost of Goods Sold
Less: Other Costs
Less: Depreciation
Pretax profit
Less: Tax
Profit after tax
5-26
Project Analysis

Cash Flow Analysis
Sales
Less: Cost of Goods Sold
Other Costs
Tax on Operations
Cash Flow from Operations
Less: Change in Working Capital
Gross Change in Capital
(Capital Investment less Disposal)
Net Cash Flow
5-27
Project Analysis
OR
Profit after Tax
Less: New Investment
Plus: Depreciation
Less: Change in Working Capital
Note That:
New Investment - Depreciation + Change in Working
Capital = Change in Total Assets,
So that Cash Flow is equal to:
5-28
Profit after tax less change in total book value of assets
Project Analysis
 Real, versus Nominal Cash Flows:
Suppose the nominal rate is 20% and anticipated inflation is 10%,
then:
Net Present Value from Initial Projections Discounted at the real
rate of:
r = (1 + 0.20)/(1 + 0.10) - 1 = 9.09%
Net Cash Flows
 Real cash flows
 Nominal cash flows
 Percentage difference, nominal against real
Net Present Value at the Real Rate
Net Present Value at the Nominal Rate
Why are they different?
5-29
Which one is correct?