Lecture 5 Project Analysis Discounted Cash Flow Analysis

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Lecture 5Project AnalysisDiscounted Cash Flow
Analysis

• Managerial Finance
• FINA 6335
• Ronald F. Singer

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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.

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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

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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.

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• 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.

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• 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

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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 flow and as its effect on taxes.

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• 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.

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• 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

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• 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 investment?

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• 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 

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• BUT the additional investment should be made.
  The incremental cash flows looks like
•  
• The Net Present Value from the incremental cash
  flow is
• And this has a NPV of

7,000
-5,000
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• 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)
• 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
• incremental cash flows.

14,000
0
Initial With Additional Investment
-1
1
15,050
-10,000
0
-1
1
-1,000
-10,000
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• 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.

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• 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

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• 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)(1in)t 
• (1in)t  
• if R is the annual nominal interest rate, and r
  is the real interest rate, then
• (1R) (1r)(1in) 
• (1r) (1R)/(1in) 
• Don't assume that all cash flows will be affected
  equally by inflation.
• Beware of the Approximation
• R r in 
• This works only if r X in is small.

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• 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)

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• 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).

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• 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!

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• 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?

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• 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  

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• 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 gt Book Value, then tax on gain is
  cash outflow.
•  If Market Value lt Book Value, then we have a
  loss on sale, tax is negative, and there is a
  cash inflow. 
• Example

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• 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

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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

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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

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Project Analysis

• Profit
• Total Sales
• Less Cost of Goods Sold
• Less Other Costs
• Less Depreciation
•   Pretax profit
•   Less Tax
•  
• Profit after tax

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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

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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 
• Profit after tax less change in total book value
  of assets

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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?
•  Which one is correct?