7-1
Fundamentals
of Corporate
Finance
Second Canadian Edition
prepared by:
Carol Edwards
BA, MBA, CFA
Instructor, Finance
British Columbia Institute of Technology
copyright © 2003 McGraw Hill Ryerson Limited
7-2
Chapter 7
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
copyright © 2003 McGraw Hill Ryerson Limited
7-3
Discount Cash Flows
• 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.
copyright © 2003 McGraw Hill Ryerson Limited
7-4
Discount Cash Flows
• Discount

Cash Flows not Profits
In this chapter, you will learn more about
Step 1:

How to prepare cash flow estimates for use
in a NPV analysis.
This is not as easy as it sounds …
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7-5
Discount Cash Flows
• 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 cash flows, which are
necessary for a NPV analysis.
copyright © 2003 McGraw Hill Ryerson Limited
7-6
Discount Cash Flows
• Discount


Cash Flows not Profits
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.
copyright © 2003 McGraw Hill Ryerson Limited
7-7
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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7-8
Discount Cash Flows
• Discount

Cash Flows not Profits
Accounting NPV:
+500
+ -500 = $41.32
1.10
1.10
ACCEPT THE PROJECT

NPV of Cash Flow:
-2,000
1.10
+ +1,500 + +500 = -$223.14
1.10
1.10
REJECT THE PROJECT
copyright © 2003 McGraw Hill Ryerson Limited
7-9
Discount Cash Flows
• 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!

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7 - 10
Discount Cash Flows
• Discount

Cash Flows not Profits
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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7 - 11
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.
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7 - 12
Discount Incremental Cash Flows
• Look
for Incremental Benefits
Cash Flow
Incremental Cash Flow = with the
Project
-
Cash Flow
without the
Project
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7 - 13
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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7 - 14
Discount Incremental Cash Flows
• Look

for Incremental Benefits
Example 7.2 in your text:


Intel is considering launching the Pentium III
microprocessor.
Cash flows from the sale of the new processors
are expected to be in the billions.
But, will these be incremental cash flows?
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7 - 15
Discount Incremental Cash Flows
No! These will not be
incremental cash flows!
• Look

for Incremental Benefits
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 II chips will fall.
Cash flows from the sale of Pentium III chips
must be reduced by the decrease in cash flows
from Pentium II chips.
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7 - 16
Discount Incremental Cash Flows
• Look
for Incremental Benefits
Incremental
Cash Flow
=
=
Cash Flow
with the
Project
Cash Flow from
the Pentium III
plus the reduced
cash flow from
the Pentium II.
-
Cash Flow
without the
Project
Cash Flow without
the Pentium III
- plus the higher
cash flow from the
Pentium II
copyright © 2003 McGraw Hill Ryerson Limited
7 - 17
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:
 Include all Indirect Effects
 Forget Sunk Costs
 Include Opportunity Costs
 Recognize Investment in Working Capital
 Beware of Allocated Overhead Costs
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7 - 18
Discount Incremental Cash Flows
• Include


all Indirect Effects
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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7 - 19
Discount Incremental Cash Flows
• 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.

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7 - 20
Discount Incremental Cash Flows
• Forget

Sunk Costs
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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7 - 21
Discount Incremental Cash Flows
• Include

Opportunity Costs
Most resources are not free, even if no
money changes hands.
 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.
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7 - 22
Discount Incremental Cash Flows
• Include
Opportunity Costs
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.
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7 - 23
Discount Incremental Cash Flows
• Include

Opportunity Costs
If we build the factory, we give up $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.
 Did
you recognize it as a sunk cost?
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7 - 24
Discount Incremental Cash Flows
• Recognize

Net working capital is the difference between a
firm’s short-term assets and liabilities.
 It
includes:


Investments in Working Capital
Cash, Accounts Receivable and Inventories.
Most projects entail an additional investment in
working capital.
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7 - 25
Discount Incremental Cash Flows
• Recognize


Investments 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.
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7 - 26
Discount Incremental Cash Flows
• Recognize


Investments in Working Capital
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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7 - 27
Discount Incremental Cash Flows
• 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.
 An accountant may assign such costs to a
project after it has been accepted.
But, should they be included when
deciding whether to accept the project?
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7 - 28
Discount Incremental Cash Flows
• Beware

of Allocated Overhead Costs
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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7 - 29
Nominal and Real Cash Flows
• 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.
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7 - 30
Nominal and Real Cash Flows
• Discount
Nominal Cash Flows by the
Nominal Cost of Capital

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 7.3.
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7 - 31
Financing vs Investment
• Separate
Investment and Financing
Decisions

When analyzing a project, the first step is to
determine whether it is worth undertaking.
 In
other words, first determine whether the project
has a positive NPV.

If the project is worth undertaking, then you
determine how to finance it.
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7 - 32
Financing vs Investment
• Separate
Investment and Financing
Decisions

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.

If the project will benefit the shareholders,
then you can conduct a separate analysis of
the financing decision.
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7 - 33
Calculating Cash Flow
• Total
cash flows are the sum of 3 components:
1. Cash flow from investments in plant and
equipment.
 Most
projects need upfront capital investments.
2. Cash flow from investment in working capital.
 Most
projects require cash holdings, accounts
receivable and inventory.
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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7 - 34
Calculating Cash Flow
• Cash

flow from operations (CFO)
There are several ways to work out CFO:
Method 1
Cash Revenues – Cash Expenses – Taxes Paid
Method 2
Net Profit + Depreciation
Method 3
(Cash Revenues – Cash Expenses)
x (1- tax rate) + (depreciation x tax rate)
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7 - 35
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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7 - 36
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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7 - 37
Calculating Cash Flow
• Cash

Flow from Operations (CFO)
Note that all 3 methods of calculating the cash
flow from operations gave the same answer.
 CFO
= $ 330
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7 - 38
Taxes and Cash Flows
• 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
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7 - 39
Taxes and Cash Flows
• Business
Taxes in Canada and the
Capital Budgeting Decision


The terms depreciation and CCA are often
used interchangeably.
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 Customs
and Revenue.
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7 - 40
Taxes and Cash Flows
• Business
Taxes in Canada and the
Capital Budgeting Decision



Depreciation cannot affect a company’s cash
flows – it is only a book entry.
Only 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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7 - 41
Taxes and Cash Flows
• Business
Taxes in Canada and the
Capital Budgeting Decision

Capital Cost Allowance (CCA)
 The
amount of write-off on depreciable assets
allowed by Canada Customs and Revenue against
taxable income.

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.
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7 - 42
Taxes and Cash Flows
• Business
Taxes in Canada and the
Capital Budgeting Decision

For calculating CCA, assets are assigned to
different asset classes.
 These


classes have specified CCA rates.
Most asset classes use a declining balance
method for computing CCA.
CCA is deducted from operating earnings
before calculating taxes.
 This
reduction in earnings creates a tax shield.
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7 - 43
Taxes and Cash Flows
• Business
Taxes in Canada and the
Capital Budgeting Decision

The tax shield generated by CCA generally has
an infinite life.
 Most

projects have a limited life span.
As a consequence, when computing NPV, we
calculate the present value of the operating
cash flow separately from the present value of
the CCA tax shields.
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7 - 44
Summary of Chapter 7
• Here
is a checklist to bear in mind when
estimating a project’s cash flows:
 Discount cash flows not profits.
 Estimate incremental cash flow:

That is, the difference between the cash flows with the
project and those without the project.
 Forget sunk costs.
 Don’t forget opportunity costs.
 Beware of allocated overhead charges (e.g. for
heat, light and power) which my not reflect the
incremental costs of the project.
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7 - 45
Summary of Chapter 7
• Here
is a checklist to bear in mind when
estimating a project’s cash flows:
 Remember investment in working capital.
 Do not forget that working capital will fluctuate
over the life of the project.
 Do not forget to recover the working capital at
the end of the project.
 Separate the investment and financing decision:

Do not include debt interest or loan costs in evaluating
a project. Treat it as an all equity financed project for
purposes of evaluation.
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7 - 46
Summary of Chapter 7


If you forecast nominal cash flows, which reflect
the effect of inflation, discount those cash flows
using a nominal cost of capital.
In Canada, a company’s tax bill is determined
by its CCA, not its book depreciation.
 Use
CCA when calculating the project’s cash
flows.
 CCA tax shields have an infinite life. Projects
have a fixed life.

Calculate the PV of the CCA tax shields
separately from the PV of the operating cash
flows when computing a project’s NPV.
copyright © 2003 McGraw Hill Ryerson Limited