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Using Discounted Cash Flow Analysis to Make Investment Decisions

There are many factors that affect the level and timing of project cash flows

Need to estimate project cash flows

Need to estimate opp. Cost of capital

Use the opp. cost of capital to discount future cash flows

Calculate the NPC


Identifying Cash Flows

Discount Cash Flows, Not Profits

Income statements show how well the company has performed, they do not track cash flows

Capital expenditures are depreciated as opposed to being deducted when calculating income

Current outlay may deduct the depreciation form the cash flow to obtain accounting income

When calculating NPV, we need to recognize investment expenditures when they occur, not when
they show up as depreciation

Focus of capital budgeting must be on cash flow, not profits

Discount Incremental Cash Flows

Forget Sunk Costs

Projects PV depends on the extra cash flow


that it produces

Need to trace all incremental flows from a


proposed project in capital budgeting

Sunk costs remain the same whether or not


you accept a project; they do not affect the
project NPV

Need to evaluate how much more resources


are needed to complete certain projects and
whether the established project warranted the
incremental investment

Include All Indirect Effects

New products may sometimes damage sales


of existing products

Some capital investments have long lives


once all indirect effects are recognized

Include Opportunity Costs

Opportunity cost: benefit or cash flow foregone as a result of an action

o
-

Equals the cash that could be realized from selling the project now; it is a relevant cash
flow for project evaluation

Sometimes there is no out-of-pocket cost, but there is an opportunity cost

If you use land that can otherwise be sold for $100000, you have given up that amount by
undertaking the project

Original cost of purchasing the land is irrelevant (sunk cost)

When resources can be freely traded, opp. cost = market price

Recognize the Investment in Working Capital

Net working capital: current assets current liabilities

Investments in working capital result in cash outflows

Most projects entail additional investment in working capital; before starting production, a firm must
invest in inventories of raw materials

The following are a set of working capital mistakes:

Forgetting about working capital entirely

Forgetting that WC may change during life of the project

Forget that working capital is recovered at end of the project; inventories are run down, any
unpaid bills are paid and you can recover your investment in working capital

Remember Shutdown Cash Flows

Once a project is complete, you may be able to sell some of the plant, equipment or real estate that
was dedicated to it

Some investment in working capital can be recovered by selling off inventories of finished goods and
collecting outstanding AR

Beware of Allocated Overhead Costs

Sometimes, overhead costs may not be related to a particular project, but they must be paid for

When assigning costs to firms project, a charge for overhead is usually made

Principle of incremental cash flow states that we should only include the extra expense that
would result from the project

Discount Nominal Cash Flows by the Nominal Cost of Capital

Real cash flow must be discounted at real discount rate and nominal cash flow must be discounted at
nominal discount rate

Real rate of interest depends on inflation

Some costs/prices increase faster than inflation, some slower

Separate Investment and Financing Decisions

Regardless of actual financing, we should view the project as if it were all-equity-financed

o
-

All cash outflows required coming from shareholders and all inflows going to them

This allows you to separate analysis of the investment decision from that of the financing decision
Calculating Cash Flows

Capital Investment

Company will need to make considerable up-front investment in PPE, research, marketing to get a
project off the ground

This is a negative cash flow

Salvage value represents positive cash flow to the firm

Significant shutdown costs can include further negative cash flows

Investment in Working Capital

Cash is reduced when building up inventories of raw material or finished goods

Cash is reduced when customers are slow to pay their bills (firm makes investment in AR)

Investment in WC is reduced when AR is collected and when inventories are sold

Cash flow is measured by change in working capital, not the level of WC

Operating Cash Flow

Consists of any revenues from sale less costs of production and taxes

Some investments are there to reduce costs of existing operations (create efficiencies)

Method 1: Dollars in Minus Dollars Out

Take only the items from the income statement that represent cash flows

Depreciation is not subtracted, because it is an accounting entry, not a cash expense

Method 2: Adjusted Accounting Profit

Start with after tax accounting profit and add back any deductions that were made for non-cash
expenses (depreciation)

Method 3: Tax Shields

Depreciation deduction does affect net profits and the amount of taxes paid

Depreciation tax shield: reduction in taxes attributable to the depreciation allowance

Need to get net profit assuming 0 depreciation and then add tax shield created by depreciation

all three methods for estimating operating cash flow give the same answer
Business Taxes in Canada and the Capital Budgeting Decision

Depreciation and Capital Cost Allowance

businesses can deduct and amount for depreciation o its depreciable assets before calculating taxable
income

Capital cost allowance (CCA): the amount of write-off on depreciable assets allowed by CRA
against taxable income

Un-depreciated capital cost: balance remaining in an assets class that has not yet been
depreciated in that year

CCA tax shield: tax savings from the CCA charge

Only the CCA amount has an effect on the companys cash flows

Asset Class System

Asset class: eligible depreciable assets are grouped into specified asset classes by CRA; each asset
class has prescribe CCA rate

Intangible assets or patents follow straight line depreciation method for computing CCA

Straight line depreciation: constant depreciation for each year of the assets accounting life

Declining balance depreciation: computed by applying the depreciation rate to the asset balance for
each year

Half year rule: only of the purchase cost of the asset is added to the asset class and used to
compute CCA in the year of purchase

Sales of Assets

A company is entitled to CCA as long as it owns at least one asset in the asset class

Adjusted cost of disposal: when depreciable asset is sold, undepreciated capital cost of the asset
class is reduced by sale price or initial cost

Net acquisitions rule: determine total cost of all additions to an asset class and then subtract adjust
cost of disposal of all assets in that class

If net acquisitions is positive, we would apply year rule and calculate CCA

If net acquisitions is negative, we would subtract the amount from beginning UCC balance of
the asset class

Termination of Asset Pool

Terminal loss: positive balance following the disposal of all assets in the class. UCC of the asset class
is set to 0 after a terminal loss is recognized

Deducted from taxable income

Recaptured depreciation: the negative balance that is caused in an asset class by sale of an asset. It
is added to taxable income

Capital gains, net of any capital losses, are taxed at 50% of firms applicable marginal tax rate

PV of CCA Tax Shields

: capital cost of an asset acquired at beg. Of


year 1

T: firms tax rate

R: discount rate
S: salvage amount from the sale of the asset
at end of year t

D: CCA rate for asset class to which the


asset belongs

UCC: un-depreciated capital cost in year t


after deducting CCA for the year

CCA tax shield from investing in an asset can continue in perpetuity

We seek for incremental changes in CCA and UCC that arise because of the purchase/sale of
assets for the project

For an asset to generate CCA tax shields even after it is sold: there must be other assets
remaining in the class, and the proceeds from disposing of any assets are less than total UCC for the
asset class
Example: Blooper Industries

Capital Investment
Project requires investment of $10
million in mining machinery; no further
value after five years

As project gears up in early years,


WC increases, but later, investments
in WC are recovered

Revenues

CCA rate of 30%

The firm has other assets in this asset


class

Company can earn initial revenue of


$15 million

Inflation is at 5%/year; the company


should up the forecast of the 2nd year
revenues by inflation rate

Working Capital

Expenses: assumed to increase in line with


inflation of 5%/year

CCA: computed using declining balance


method; system will continue to provide
smaller CCA values each year over an infinite
period

Pre-tax Profits: revenues expenses - CCA

Profit after Tax: pre-tax profit less taxes

Further Notes and Winkles Arising from Bloopers Project: salvage value will reduce future tax shields
and the PV of CCA tax shields

CRA only lets companies depreciate amount of the original investment; nominal amount of CCA is
fixed

Higher the rate of inflation, lower the real value of CCA that you can claim