Ch 9 Cash Flow Analysis PDF

CH. 9: Cash flow analysis 1  A Review of two approaches to project valuation 1. NPV NPV=PV of all CFs from the project – initial investment If NPV > 0, then the project is worth more than it costs and therefore it should be accepted. Otherwi...

CH. 9: Cash flow analysis 1  A Review of two approaches to project valuation 1. NPV NPV=PV of all CFs from the project – initial investment If NPV > 0, then the project is worth more than it costs and therefore it should be accepted. Otherwise, it should be rejected. The discount rate is called the opportunity cost of capital. 2. IRR The IRR of a project is defined as the discount rate which makes t theCF NPV of the project equal to zero.  I   i 1 (1  i IRR ) i 0 If IRR is greater than the opportunity cost of capital, then accept the project; otherwise, reject it. 2  Forecasting CFs and discounting CFs 1. Discounting CFs not profits To calculate CF, it is necessary to add back the depreciation charge and subtract any new expenditure on new investments. Example: If a firm lays out $100,000 on a capital project, the entire $100,000 is an immediate cash outflow on date 0. However, accountants do not deduct the $100,000 when calculating that year’s income. Instead, they depreciate it over several years. Assume that the project lasts for 5 years, accountants would depreciate that $100,000 over 5 years and deduct the depreciation from the CF to obtain accounting income. 3  Profits vs CFs Example: A project costs $2,000 today 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 in Years 1 and 2, respectively. The asset can be depreciated at $1,000 per year. Compare the NPV using cash flows, to the NPV using accounting income. 4  Profits vs CFs t=0 t=1 t=2 Cost (C0) (2,000) Cash Income 1,500 500 Cash Flow (2,000) 1,500 500 Cash Income - 1,500 500 Depreciation - (1,000) (1,000) Accounting Income - 500 (500) 5  Profits vs CFs Accounting NPV: +500 + - = $41.32 500 ACCEPT THE PROJECT 1.10 1.10^2 NPV of Cash flow: -2,000 + +1,500 + = -$223.14 +500 1.10 REJECT THE PROJECT 1.10^2 6 Forecasting CFs and discounting CFs Accountants try to show profit as it is earned, rather than when the company and the customer get around to paying their bills. For example: an income statement will recognize revenues when the sale is made even if the bill is not paid for months. The sale generates immediate profits but the CFs come later. 7  Forecasting CFs and discounting CFs 2. Discounting incremental CFs Incremental CFs are the changes in the firm’s CFs that occur as a direct consequence of accepting the project. Incremental CFs = CFs with project – CFs without project 8  Forecasting CFs and discounting CFs Look for Incremental Benefits – Would this cash flow still exist if the project did not exist? If the answer is No? Yes? Include the cash flow Do not include the in the analysis. cash flow in the analysis. 9  Forecasting CFs and discounting CFs Incremental CFs a) Include all the indirect effects (side effects). To forecast incremental CFs, you must trace out all indirect effects of accepting the project. Cannibalization: A new project might hurt sales of an existing product. – Launching a faster microprocessor will hurt the sales of the existing model. Sales creation: A new project might help sales of an existing product. – Adding a new route into an airport would increase traffic, adding new revenues. – It is the opposite of cannibalization. 10 Forecasting CFs and discounting CFs b) Ignore sunk costs. A sunk cost is a cost that has already occurred. For example, a firm is currently evaluating the NPV of a new project. As part of the evaluation, the firm had paid a consulting firm $100,000 to perform a test marketing analysis. The expenditure was made last year. This cost is not relevant for capital budgeting decision now, because the $100,000 is not recoverable, so the $100,000 expenditure is a sunk cost, or spilled milk. 11 Forecasting CFs and discounting CFs c) Include opportunity costs If an asset is used in a new project, potential revenues from alternative uses are lost. These lost revenues can be viewed as costs. They are called the opportunity cost of capital, as by taking the project the firm foregoes other opportunities for using the assets. d) Overhead costs Only those incurred by accepting the project represent the incremental CFs. 12  Forecasting CFs and discounting CFs 3. Separate investment and financing decisions Evaluate the project assuming all- equity financing Undertake a separate analysis of the financing decision. 13  Forecasting CFs and discounting CFs 4. Discounting nominal CFs at the nominal interest rate 1+real rate = (1+nominal rate)/(1+inflation rate) If inflation rate >0, then real rate 0. It is called a 0 terminal loss. The terminal loss is deducted from the taxable income. – Tax shield on terminal loss = 21,650 × 40% = $8,660 If the sale price S = 50,000, so adjusted cost of disposal = $50,000. – UCC0(4) – 50,000 = 41,650 – 50,000 = -$8,350