8-1
Chapter 8
Using Discounted Cash Flow Analysis
Chapter Outline







Discount Cash Flows, Not Profits
Discount Incremental Cash Flows
Discount Nominal Cash Flows by the Nominal
Cost of Capital
Separate Investment and Financing Decisions
Calculating Cash Flow
Business Taxes in Canada and the Capital
Budgeting Decision
Example: Blooper Industries
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8-2
Discount Cash Flows not Profits

In Chapter 6 you learned to evaluate a project:

Step 1: Forecast the projected cash flows.

Step 2: Estimate the opportunity cost of capital.

Step 3: Discount the cash flows at the opportunity
cost of capital.

Step 4: Calculate the NPV where
NPV = PV of Cash flows – Initial Investment


Decision: Go ahead with the project if NPV  0.
In this chapter, you will learn how to prepare cash flow
estimates for use in a NPV analysis. That is we will
discount cash flows not accounting profits.
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8-3
Discount Cash Flows not Profits

Remember, forecasts of cash flows will not arrive on a
silver platter, all ready to go into your analysis!


You will have to deal with raw data supplied by consultants,
production, marketing, etc.
You will also have to adjust data prepared in accordance with
accounting principals.



Accounting numbers use historic costs and accounting income, not
market values and CFs, which are necessary for a NPV analysis.
Discounting accounting income, rather than cash flow, will
lead to erroneous decisions.
For example: A projects cost $2,000 (C0) and has an
opportunity cost of capital of 10%. It has a 2 year life.



It will produce cash revenues of $1,500 and $500.
The project can be depreciated at $1,000 per year.
Compare the NPV using cash flow to the NPV using accounting
income.
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8-4
Discount Cash Flows
• Discount
Cash Flows not Profits
Cost (C0)
Cash Income
Cash Flow
Cash Income
Depreciation
Accounting Income
t=1
t=2
(2,000)
1,500
1,500
500
500
-
1,500
(1,000)
500
500
(1,000)
(500)
t=0
(2,000)
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8-5
Discount Cash Flows
• Discount

Cash Flows not Profits
Accounting NPV:
+500
+ -5002 = $41.32
1.10
1.10
ACCEPT THE PROJECT

NPV of Cash Flow:
-2,000
+ 1,500 + 500 2 = -$223.14
1.10
1.10
REJECT THE PROJECT
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8-6
Discount Cash Flows not Profits

Discounting the accounting income gives an entirely
different result from discounting the cash flows!


The Accounting NPV says to accept the project.
However, this answer makes no sense:



The project is obviously a loser, since we only get our money
back ($1,500 + $500 = $2,000 or the cost).
This means we are getting a zero return when we could be
getting 10% in the market!
The NPV of the cash flows gives the correct answer:
This project is undesirable and should be rejected!
Remember:
 Projects are attractive because of the cash flow they generate.
 Therefore, the focus of capital budgeting must be cash flows and
not profits.


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8-7
Discount Incremental Cash Flows
• Look


for Incremental Benefits
A project’s NPV depends on the extra cash flows it
produces.
You should:
1. Calculate the firm’s cash flows if it goes ahead with the project.
2. Calculate the cash flows if the firm doesn’t go ahead with the
project.
3. Take the difference, which gives you the extra, or incremental,
cash flow of the project.
Cash Flow
Incremental Cash Flow = with the
Project
-
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Cash Flow
without the
Project
ADMS 3530
8-8
Discount Incremental Cash Flows
• Look

for Incremental Benefits
You may wish to ask yourself:

Would this cash flow still exist if the project did
not exist?
No?
Yes?
Include the cash flow in
the analysis.
Do not include the cash
flow in the analysis.
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8-9
Discount Incremental Cash Flows
• Look



for Incremental Benefits
Intel is considering launching the Pentium 4 microprocessor.
Cash flows from the sale of the new processors are expected to
be in the billions.
But, will these be incremental cash flows?
Our with-versus-without principle means we must also
think about the cash flows without the new processor.


If Intel goes ahead with the new processor, then demand for
Pentium 3 chips will fall.
Cash flows from the sale of Pentium 4 chips must be reduced by the
decrease in cash flows from Pentium 3 chips.
Incremental
Cash Flow
=
Cash Flow from P4
(including reduced
cash flow from P3)
-
Cash Flow without P4
(including higher cash
flow from P3)
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8 - 10
Discount Incremental Cash Flows
•
Look for Incremental Benefits

The trick in capital budgeting is to include all
the incremental cash flows from a proposed
project.

Here are a some things to look out for:
1. Include all Indirect Effects
2. Forget Sunk Costs
3. Include Opportunity Costs
4. Recognize Investment in Working Capital
5. Beware of Allocated Overhead Costs
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8 - 11
Discount Incremental Cash Flows
Include all Indirect Effects
1.


To forecast incremental cash flows, trace out
all the indirect effects of accepting a project.
For example:

Sometimes a project will hurt sales of an existing
product.


Think of the Intel example we looked at.
Sometimes a project will help sales of an existing
product.

Adding a new route into an airport would increase
traffic, adding new revenues.
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8 - 12
Discount Incremental Cash Flows
2. Forget Sunk Costs



Sunk costs are like spilled milk: they are past and
irreversible outflows!
The way to identify a sunk cost is to see if it remains
the same whether or not you accept the project.
For example: Your firm paid $100,000 last year for a marketing
report for a new widget it has developed.
 If you pursue the new widget project, the cash flow for the
marketing report is $100,000.
 If you do not pursue the new widget project, the cash flow for
the marketing report is $100,000.
This is a sunk cost … it remains the same whether or not
you accept the project.
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8 - 13
Discount Incremental Cash Flows
3. Include Opportunity Costs

Most resources are not free, even if no money changes hands.





If your firm builds the factory, there is no out-of-pocket cost for the land.
However, there is an opportunity cost.



That is the value of the foregone alternative use of the land.
It could be sold for $100,000.
If we build the factory, we give up $100,000.



Suppose your firm is considering building a factory on some land.
Your firm purchased this land for $50,000.
Its market value today is $100,000.
Thus the opportunity cost equals the cash that could be realized from selling
the land now.
This is the relevant cash flow for the project evaluation.
Notice that the purchase price of the land is irrelevant to analyzing the
project-that cost is sunk.
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8 - 14
Discount Incremental Cash Flows
4. Recognize Investments in Working Capital

Net working capital is the difference between a firm’s short-term
assets and liabilities.


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
ST assets include Cash, Accounts Receivable and Inventories.
ST liabilities include accounts payable, notes payable, and accruals.
Most projects entail an additional investment in working capital.
Investments in working capital, just like investments in plant and
equipment, result in cash outflows.
At the end of the project, when inventories are sold and accounts
receivable are collected, the firm has a cash inflow.
Working capital is one of the most common sources of confusion in
forecasting project cash flows. Here are the most common mistakes:


Forgetting working capital entirely.
Forgetting that working capital may change during the life of the project.


Cash holdings, A/R and inventories will fluctuate over the life of the project.
Forgetting that working capital is recovered at the end of the project
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8 - 15
Discount Incremental Cash Flows
5. Beware of Allocated Overhead Costs
 Accountants will allocate costs, such as rent, heat, or
electricity to a firm’s operations.


Allocated costs are not related to any particular project, but they
must be paid anyways.
When analyzing a project for acceptance, include only the
extra expenses which would result from the project.


If a project generates extra overhead costs, they should be
included in your analysis.
However, if the firm would incur the overhead costs whether it
takes on the project or not, then those costs are not incremental.

If they are not incremental, they should not be included in the
analysis.
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8 - 16
Discount Nominal Cash Flows by the
Nominal Cost of Capital


Real cash flows must be discounted at a real discount rate.
Nominal cash flows must be discounted at a nominal rate.


Mixing and matching nominal and real quantities, such as
discounting real cash flows at a nominal rate, will lead to incorrect
decisions.
As long as you are consistent in your treatment of the cash
flows, you will get the same results whether you use nominal or
real figures. (See Example 8.3)
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Separate Investment and
Financing Decisions
8 - 17
•
When analyzing a project, the first step is to determine
whether it is worth undertaking. (I.e. positive NPV).
• If the project is worth undertaking, then you determine how
to finance it.
• Even if a part of a the financing will come from debt, the
interest and principal payments should not be recognized
as cash outflows.
• Thus, when you calculate the cash flows from a project,
ignore how the project is to be financed.

•
Analyze the project as though it were all equity financed, treating
all the cash flows as coming and going to shareholders.
If the project will benefit the shareholders, then you can
conduct a separate analysis of the financing decision.
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8 - 18
Calculating Cash Flows
•
Total cash flows are the sum of 3 components:
1. Cash flow from investments in plant and equipment.

Most projects need upfront capital investments in plant,
equipment, research, marketing etc. These expenditures are
negative CFs. If the machinery is sold at the end, the
proceeds will be a positive CF.
2. Cash flow from investment in working capital.

Most projects require cash holdings, accounts receivable and
inventory. An increase in working capital implies a negative
cash flow, a decrease implies a positive CF. The CF is
measured by the change not the level of working capital.
3. Cash flow from operations.

A firm invests in plant, equipment and working capital in the
expectation that they will generate operating cash flows.
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Calculating Cash Flow
• Cash
flow from operations (CFO)
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8 - 20
Calculating Cash Flow
• Cash flow from operations (CFO)
 Given the Income Statement below, calculate
the cash flow from operations using the 3
methods:
Cash Revenues
- Cash Expenses
- Depreciation Expense
= Profit before Tax
- Tax @ 35%
= Net Income
$1,000
600
200
200
70
130
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8 - 21
Calculating Cash Flow
• Cash
flow from operations (CFO)
Method 1
Cash Revenues – Cash Expenses – Taxes Paid
= 1,000 - 600 - 70 = $ 330
Method 2
Net Profit + Depreciation = $130 + 200 = $ 330
Method 3
(Cash Revenues – Cash Expenses)
x (1- tax rate) + (depreciation x tax rate)
= ($1,000 - 600) x (1- 0.35) + (200 x .35) = $ 330
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8 - 22
Business Taxes in Canada and the Capital
Budgeting Decision

So far, we have calculated taxable income by deducting
depreciation: Taxable Income = Revenues - Expenses - Depreciation

However, in Canada, taxable income is based on a deduction
called Capital Cost Allowance (CCA), not on depreciation:
Taxable Income = Revenues - Expenses - CCA

Although both are forms of amortization, they are not necessarily
calculated the same way.




The depreciation a company reports on its income statement is
generally calculated in a different manner from the CCA it reports to
Canada Revenue Agency.
Depreciation cannot affect a company’s cash flows – it is only a
book entry.
The CCA amount has an effect on cash flows by reducing actual
taxes payable.
Thus you must substitute CCA for depreciation in your
calculations of the cash flows from a project.
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Business Taxes in Canada and the Capital
Budgeting Decision
•
Capital Cost Allowance (CCA)

The amount of write-off on depreciable assets allowed by Canada
Revenue Agency against taxable income.



•
8 - 23
It is calculated by multiplying UCC by the appropriate CCA rate. The
CCA rate is assigned according to an asset class system (see Table
8.1 on page 252)
Most asset classes use a declining balance method for computing
CCA: apply the CCA rate to the balance for each year.
The half-year rule consists in adding only one-half of the purchase
cost of the asset to the asset class and use it to compute CCA in
the year of purchase. The remaining half of the cost will be added
to the class next year.
Undepreciated Capital Cost
The balance remaining in an asset class that has not yet been
depreciated in that year.
• CCA Tax Shield: Tax savings arising from the CCA charge.

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Business Taxes in Canada and the
Capital Budgeting Decision
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Business Taxes in Canada and the
Capital Budgeting Decision
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Business Taxes in Canada and the
Capital Budgeting Decision
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Business Taxes in Canada and the
Capital Budgeting Decision
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Business Taxes in Canada and the
Capital Budgeting Decision
PV of CCA Tax Shields
To properly calculate the NPV of a project we must
calculate the PV of the OCFs separately from the PV
of the CCA tax shield.
 Because a project has a finite life while
 The CCA tax shield may have an infinite life.
 An asset can continue to generate CCA tax shields
for the firm even after it is sold.
 So CCA tax shield from investing in an asset can
continue in perpetuity.
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Present Value of CCA Tax Shields
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Present Value of CCA Tax Shields
Example:8.9 on page 256
55,954 - 763 = 55,191
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Present Value of CCA Tax Shields
Example 8.9, page 256
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Example: Blooper Industries
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Example: Blooper Industries
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Example: Blooper Industries
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Example: Blooper Industries
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Example: Blooper Industries
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Example: Blooper Industries
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