Applied Corporate Finance

Course Overview, NPV, and Capital Budgeting

Professor Dimas Fazio

National University of Singapore Business School

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Hi!
PhD in Finance (London Business School)

Email
dimasfazio@nus.edu.sg

Office
BIZ 1 - #07-62

Consultation Hours
Upon Schedule

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Course Goals: To Answer
01 How to make better financial decisions?

02 How to calculate the “true” value of a firm

03 The benefits and costs of different types of

financing

04 Application: Corporate Restructurings

• M&A, Bankruptcy, Shareholder Activism

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 Discuss:
What is Corporate Finance?

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Corporate Finance: What is it?
“Every decision that a business makes has
financial implications, and any decision
which affects the finances of a business is
a corporate finance decision.

Defined broadly, everything that a business

does fits under the rubric of corporate
finance”

Aswath Damodaran
Kerschner Family Chair in Finance
Education at NYU

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The Goal of the Firm

The Objective of the Firm (CEO/CFO):

MAXIMISE VALUE

Need to know:

How to make good investment How to finance these

decisions decisions/projects?

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Flow of Cash Between Investors
and the Firm’s Operations

(3) (5)

Financial Decision Investors (Financial Institutions,

Firm’s Operations (4)
Maker Individuals, Other Firms)

(2) (1)

(1) Cash raised from investors by selling financial assets

(2) Cash invested in real assets (some are intangible)
(3) Cash generated by operations
(4) Cash reinvested in the firm (retained earnings)
(5) Cash repaid to investors (interest, dividends, etc)

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The Goal of the Firm
The Objective = Create Value

How?
Investment Decisions Financing Decisions
How to select projects that
increase the value of the firm? How to finance an investment
project?

“Good” Financial decision: Need to know the cost of the

Present Value of Benefits > different sources of finance (debt,
Present Value of costs equity)

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 Discounting and the
Net Present Value (NPV)

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Why do we need discounting?
What would you prefer?
I give you S$ 100 now or S$ 100 in one year?

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Why do we need discounting?
What would you prefer?
I give you S$ 100 now or S$ 100 in one year?

What if I give you two options:

a) Receive S$ 100 now with 100% probability
b) Receive S$ 300 now with 50% probability AND you
give me S$ 100 now with 50% probability?

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Why do we need discounting?
What would you prefer?
I give you S$ 100 now or S$ 100 in one year?

What if I give you two options:

a) Receive S$ 100 now with 100% probability
b) Receive S$ 300 now with 50% probability AND you
give me S$ 100 now with 50% probability?

Why?
Time Value of Money
Risk aversion

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Investment Decision Criteria
To select projects that increase the value of the firm, we have to
evaluate expected cash flows.

$$ %

Net Present Internal Rate of Payback Return on

Value Return Assets

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Present Value
• Assume a stream of cash flows 𝐶1 , 𝐶2 , 𝐶3 , … where the subscripts denote time periods

• The Present Value (PV: value at period 0) of these stream of cash flows is

𝐶1 𝐶2 𝐶3
𝑃𝑉 = + 2
+ 3
+⋯
1+𝑟 1+𝑟 1+𝑟

• r: is the discount rate. Its calculation will be discussed in the next section

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Perpetuity
• Consider periodic and fixed payments which continue forever

Year 0 𝟏 𝟐 𝟑 4 …
CF 0 C C C C …

• Examples:
• Perpetual bonds
• Long-horizon projects
𝐶
𝑃𝑉 𝑜𝑓 𝑝𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 =
𝑟
• Numerical example:
• Discount rate = 10%
• C = $100
100
𝑃𝑉 = = $1000
0.1
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Perpetuity with Growth
• An asset whose payment increases at a steady rate g in perpetuity

• Assume discount rate r

𝐶
𝑃𝑉 =
𝑟−𝑔

• Numerical example:
• Discount rate = 10%
• Growth rate = 5%
• C = $100
100
𝑃𝑉 = = $2000
0.1 − 0.05

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Annuity
• Consider periodic and fixed payments which continues for T periods
Year 0 𝟏 𝟐 𝟑 4 … T
CF 0 C C C C … C

𝐶 1
𝑃𝑉 𝑜𝑓 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 1− 𝑇
𝑟 1+𝑟

• Example: monthly mortgage payment

• Numerical Example
• Discount rate = 10%
• C = $100, T = 20
100 1
Answer: 𝑃𝑉 = 1− = $851.36
0.1 1+10% 20

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 True or False?
Since Perpetuity is only used for
infinite periods cash flows, it should
not be used in practice

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Annuity vs Perpetuity
• Both are only used when cash flows are well behaved
• either constant or growing at a constant rate

• Annuities are used for small time period T

• Perpetuities can be used for long term (not necessarily infinite time horizon)
• For T > 50 it is already a very good approximation

• Another Numerical Example:

• Discount rate = 10%
• C = $100, T = 50
100 1
𝐴𝑛𝑛𝑢𝑖𝑡𝑦 = 1− 50
= $991.48
0.1 1 + 10%
100
𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑖𝑡𝑦 = = $1000
0.1
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With C = 100 and r = 10%

• For large horizons, perpetuity is a very good approximation of annuities!

• Also, usually we do not know what is the number of total periods of a

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project/firm.
Net Present Value

• The NPV is the same as PV, but the usual formula includes 𝐶0 = −𝐼

𝐶1 𝐶2 𝐶3
𝑁𝑃𝑉 = −𝐼 + + 2
+ 3
+⋯
1+𝑟 1+𝑟 1+𝑟

• A more general stream of cash flows may also have some negative values for 𝐶1 , 𝐶2 , …

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Net Present Value: Decision Rule

NPV rule: invest if NPV>0

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Net Present Value: Decision Rule

NPV rule: do not invest if NPV<0

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Example
Assume a discount rate r = 10%

Question: should we go ahead with the project?

𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑
Project A -100 20 30 60

20 30 60
𝑁𝑃𝑉𝐴 = −100 + + 2
+ 3
= −11.95
1 + 0.10 1 + 0.10 1 + 0.10

Decision?

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NPV or annual returns?

NPV measures the increase in total shareholder wealth that results from a project.
So it ties in naturally with CFO objective.

DRAWBACKS:

● Is NPV of $1m a big number? Depends! Many people like to communicate annual rates of return as well.
● If our cost of capital changes, will it be affected?
● Can we be sure that NPV > 0 if we are not precisely sure of our cost of capital?
● What if our cash flow estimates aren’t quite right?

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Internal Rate of Return
The IRR is the discount rate that makes the NPV of project cash flows equal to zero

Decision Rule

Accept the project if

IRR > Discount Rate

The cost of capital is the opportunity cost of funds.
A project has to offer a return that exceeds the return available in the capital market.

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Example
Question: should we go ahead with the project?

𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑
Project A -100 20 30 60

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20 30 60
0 = −100 + + + 10

1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 2 1+𝐼𝑅𝑅 3 5

0
-5

NPV
-10
In Excel: “=IRR(Cash Flow Cells, Guess)” or do a NPV plot -15
-20
-25
Answer: IRR = 4%. Decision? -30
0% 2% 4% 6% 8% 10% 12% 14% 16% 18%
Discount Rate

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Advantages & Disadvantages of IRR
Advantages Disadvantages

Expressed in % terms Should not be used to compare projects

Usually gives the same answer as NPV Projects may have multiple IRRs
Shows sensitivity to the cost of capital Can give the wrong answer for non-standard projects

Overall: NPV is the fundamental metric for valuation of cash flows.

But you should always compute the IRR as well.

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How IRR is bad for fly-now pay-later deals

𝑪𝟎 𝑪𝟏 𝑰𝑹𝑹 NPV (10%)

Project A -1000 1500 +50% 364
Project B 1000 -1500 +50% -364

Based on the IRR rule, one would invest in both Project A and B. Wrong!

Project A is equivalent to
earning a 50% return on
investment.
Project B is like
borrowing from a bank
that charges you 50%
interest rate. For such
deals, low IRR is good.

The rule is obvious here, but what happens if the sign of the cash
flows change more than once?
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Example: IRR might have no solutions

𝑪𝟎 𝑪𝟏 𝑪𝟐
Project -100 +120 -90

0
120 90
𝑁𝑃𝑉 = −100 + − -10
1+𝑟 1+𝑟 2 -20

-30
120 90
0 = −100 + −
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 2 -40

NPV
-50

Plot the NPV function for different -60

values of the discount rate -70

-80

NPV is always negative -90

-100
0% 100% 200% 300% 400% 500% 600% 700%
Discount Rate

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Example: IRR might have multiple solutions

𝑪𝟎 𝑪𝟏 𝑪𝟐
Project -4000 +25000 -25000

25000 25000
𝑁𝑃𝑉 = −4000 + − 3000
1+𝑟 1+𝑟 2
2000
25000 25000
0 = −4000 + −
1+𝐼𝑅𝑅 1+𝐼𝑅𝑅 2 1000

0
Two values satisfy this equation: IRR = 25% and

NPV
-1000
IRR = 400%
-2000
Suppose r = 10%. Both IRRs are larger than the -3000
opportunity cost of capital
-4000
However, NPV at 10% is negative (NPV = -1.93)
-5000
0% 100% 200% 300% 400% 500% 600% 700%
So here again looking at the IRR in isolation is a
Discount Rate
bad idea

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Mutually Exclusive Projects
Criticism 3: IRR might give the wrong decision if comparing mutually exclusive projects.

Suppose there are 2 alternative locations for a factory

Location 𝑪𝟎 𝑪𝟏 𝑪𝟐 NPV (10%) IRR(%)
A -10,000 +2,000 +12,000 1736 20%
B -10,000 +10,000 +3,125 1,674 25%
The user of IRR would choose Project B

But A has a larger NPV

That is, share value would increase more if CEO implemented project A, but the IRR rule
might push her away from the right choice!

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IRR and Project Duration
Assume a discount rate r = 10%.

- What is the NPV of each Project?

- What is the IRR of each project?
𝑪𝟎 𝑪𝟏 𝑪𝟐
Project A -100 115
Project B -100 55 69

115
𝑁𝑃𝑉𝐴 = −100 + = 4.54
1 + 0.10

55 69
𝑁𝑃𝑉𝐵 = −100 + + 2
= 7.02
1 + 0.10 1 + 0.10

𝐼𝑅𝑅𝐴 = 𝐼𝑅𝑅𝐵 = 15%

Decision? 33
IRR and Project Scale
• Project A: [-100, 150] → IRR = 50%

• Project B: [-1000, 1250] → IRR = 25%

• Assuming that they are mutually exclusive (and that you cannot change the scale), which project would you
take if the cost of capital is 10%?

• Project A has NPV = 40.

• Project B has NPV = 150.
• Shareholders would be better off with Project B.

• Why? The SCALE of Project B is larger.

• It may be better to earn a moderate return on a LARGE base than a larger return on a small base.

• The only way you can tell which is best is to compute NPV.

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Payback Period Method
Definition: number of years that it takes for the sum of expected future cash-flows to equal or
exceed the initial investment cost

Example:

Year 𝟏 𝟐 𝟑 4
CF -10 +5 +5 +6
Sum CF -10 -5 0 +6

Acceptance rule: accept projects with payback in less than T years, where T is mandated by
corporate policy

“If there are mutually exclusive projects, do the one with

shortest payback period”

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Payback Period - Advantages

Gives a feel
Relevant for capital for time Give a feel for the
constrained degree of CF Simple!
investment is
investors/firms at risk forecast risk

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Payback Period - Problems
NPV
Year 𝑪𝟎 𝑪𝟏 𝑪𝟐 𝑪𝟑 Payback
(10%)
Project A -2000 +2000 0 0 1 year -182
Project B -2000 +1000 +1000 +5000 2 years +3492

2000 0 0
𝑁𝑃𝑉𝐴 = −2000 + + 2+ 3
= −182.82
1 + 0.10 1 + 0.10 1 + 0.10

1000 1000 5000

𝑁𝑃𝑉𝐵 = −2000 + + 2+ 3
= 3492.11
1 + 0.10 1 + 0.10 1 + 0.10

Based on the Payback Rule, Project A is preferable

However, Project A has negative NPV, while project B has positive NPV

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Payback Period - Problems

Does not account for risk

in a logical way. We will
see later that projects with
high systematic risk have
higher costs of capital.

Does not account for the The calculation

time value of money essentially ignores the
value of cash flows
• But we know that when interest rates
are high, future cash flows are worth accruing after the period
less. Discuss: of payback, as shown in
• This can be corrected by using the previous example.
discounted payback
Does this mean that the
Payback Period method has
no place in your toolbox?
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Return on Assets / Accounting Rate of Return /
Return on Investment

Method:

Prepare pro-forma Income Statement and Balance Sheet for project

Divide accounting Profit by Net Assets year-by-year

Take the average over project lifetime

Advantages Disadvantages

1. Relates closely to accounting numbers 1. Does not account for time value of money or risk
measures of performance 2. Does not look at cash flows—and cash is what
investors are willing to pay you for.

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Appraisal Methods Compared

Method Cash Flow Based Considers Timing of Allows for Time Value of Consistent with
Cash Flows Money Accounting
System
ROA
X X X ✓

Payback
✓ ✓ X X

IRR
✓ ✓ ✓ X

NPV
✓ ✓ ✓ X

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What methods do CFOs use in the real world?
Evidence from Graham and Harvey (2002)

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Conclusion

• NPV as an investment criterion – why it works

• Alternative criteria: IRR, Payback, ROA

• We concluded that none of these methods can ever be better than NPV, but if you know
what you are doing they can be helpful additional tools.

$$ %

Net Present Internal Rate of Payback Return on

Value Return Assets

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 Capital
Budgeting

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Capital Budgeting

• First step: understand how to calculate cash flow using information on financial
statements

• Principle: cash flows should be calculated on an “incremental” basis

• “Incremental”: difference in a company’s cash flows with and without the project!

• If introducing a new product, the relevant cash flows are:

• Future cash flows with the new product
MINUS
• Future cash flows with the old product

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 Evaluate this statement:

Assume a firm is launching a project to

develop a new product. The projected sales of
this new product should be included in the
cash flow analysis.

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 True or False?

Assume a firm is launching a new product

today. The total R&D the firm spent in the
past to develop this product should be
included in the cash flow analysis for this
decision

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Valuation using WACC Method
The most common approach is to discount total cash flows using WACC

In this lecture, we are going to take the WACC as given. Next lecture, we will review
how to calculate it

The method is identical whether you are valuing:

A whole A new Part of a

company project company

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Unlevered Total Cash Flow
Most project appraisal and company valuation is based on total unlevered cash flow.

This means only the cash flow directly associated with the business assets and excluding financing
cash flows.

Total Cash Flow is also called

Free Cash
Unlevered Free Cash
Flow to the FCFF
Cash Flow Flow
Firm

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Total Cash Flow: discount rate

What about financial costs?

The answer is that when we discount total cash flow, we use a discount rate
(the WACC) that has an adjustment for leverage.

The discount rate includes an element that captures the cost of borrowing.

In the next lecture, we will revise the WACC

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Earnings (Net Income) and Total Cash Flow

Why do we compute Total Cash Flow instead of Net Income or Profit?

There are three main differences between earnings and total cash flow.
Earnings contain non-cash entries, such as depreciation.

Starting from earnings, we need to:

Capture
Replace Strip out the
effect of
depreciation effects of
changes in
with actual leverage
working
Capex (interest)
capital
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How to Derive Cash Flows from The Income
Statement? EBIT Method

Cash Flow = EBIT (1-t) + DEP - CAPEX – ΔNWC

• EBIT: revenue (sales) – operating costs – depreciation

• Multiply EBIT by (1-t) to get after tax earnings

• Add back DEP, and take off CAPEX

• usually calculate depreciation using the straight line method, need to consider salvage value

• Take off the increase in NWC

• Calculating NWC using the formula:
NWC = Inventory + Cash + Receivables – Payables

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How to Derive Cash Flows from The Income
Statement? EBITDA Method

Cash Flow = EBITDA (1-t) + t DEP - CAPEX – ΔNWC

• EBITDA: difference between sales and operating costs

• Multiply EBITDA by (1-t) to get after tax earnings

• Add back the tax savings t * DEP, and take off CAPEX
• usually calculate depreciation using the straight line method, need to consider salvage value

• Take off the increase in NWC

• Calculating NWC using the formula:
NWC = Inventory + Cash + Receivables – Payables

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Example
The discount rate is 10%

Investment Opportunity:
Buy machine for $1,000
Machine life is 5 years (worth nothing at the end)
Tax authority specifies straight-line depreciation
Sales $1,000/year
COSTS $650/year
COSTS exclude: Depreciation, Amortization, Tax, and Interest Expense.
Corporate Tax rate 50%

Should we go ahead?

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EBIT Method

Years
0 1 2 3 4 5
[1] Machine (Tax Value) 1000 800 600 400 200 0
[2] Sales 1000 1000 1000 1000 1000
[3] Cost 650 650 650 650 650
[4] EBITDA [2]-[3] 350 350 350 350 350
[5] Depreciation 200 200 200 200 200
[6] EBIT [4]-[5] 150 150 150 150 150
[7] EBIT (1-t) [6]*(1-0.5) 75 75 75 75 75
[8] CAPEX 1000
[9] Cash Flow [7]+[5]-[8] -1000 275 275 275 275 275

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EBITDA Method

Years
0 1 2 3 4 5
[1] Machine (Tax Value) 1000 800 600 400 200 0
[2] Sales 1000 1000 1000 1000 1000
[3] Cost 650 650 650 650 650
[4] EBITDA [2]-[3] 350 350 350 350 350
[5] EBITDA (1-t) [4]*(1-0.5) 175 175 175 175 175
[6] Depreciation 200 200 200 200 200
[7] CAPEX 1000
[8] Cash Flow [5]+t[6]-[7] -1000 275 275 275 275 275

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Why do we make these adjustments to
earnings to get total cash flow?
We have seen that the three main differences between earnings and total cash flow are:

Replace Subtracting
depreciation Adding back increases in
with actual interest working
Capex capital

We’ve already discussed the reasons for adding back interest and making the
associated tax adjustment.

Let’s discuss depreciation/capex and working capital

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Depreciation

Depreciation is an accounting charge that spreads the cost of investment over several years.

It is not a cash flow

Capex is the actual money paid out to make the investment.

It is a cash flow

Taxes authorities allow you to deduct depreciation from tax payments.

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Working Capital

• NWC = Inventory + Cash + Receivables – Payables

• Note that you subtract increases in NWC to get to cash flow. So…
• Cash Flow falls if you invest funds to increase the firm’s inventory.
• Cash Flow falls if your Receivables increases. Why? You have booked the revenues
before getting the cash.
• Cash Flow increases if your Payables increases. Why? You have booked the expenses
before having paid cash to your suppliers

• A refinement: cash
• When valuing a company I recommend you include cash in NWC only if it is required to
operate the business

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Amortization
• When a firm makes an acquisition, the price paid often exceeds the book value of the
assets

• The difference is called goodwill and is amortized (declines in value over time).

• Amortization is very like depreciation

• Amortization is not a cash flow and needs to be added back on to EBIT or Net Income
to get cash flow.

• Note: in many languages, a word resembling “amortization” is used to mean

depreciation.

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Salvage Value

• When an asset is disposed of, it will have a scrap or salvage value which is a
positive cash flow.

• Cash Flow = proceeds from selling the equipment +/- tax effect

• Three possibilities
• Sale Price = Book Value ⇒ Cash Flow = Proceeds
• Sale Price < Book Value ⇒ Cash Flow = Proceeds + Tax Rate x Book Loss
• Sale Price > Book Value ⇒ Cash Flow = Proceeds – Tax Rate x Book Gain

60
Sunk Costs and Opportunity Costs

Sunk Costs
• Costs that have been incurred in the past (i.e., past marketing expenditure, R&D)
• These costs are gone and are irrelevant in future investment decisions

Opportunity Costs
• In contrast, using an asset that you currently own in a project has a cost even if you already own it
• This is because if you don’t go ahead with the project, you could always sell this asset.

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Financing Costs

• Types of financing costs

• Dividend payments, interest payments, principal payments
• Cash flows not related to the actual project, but to the financing of the project

• We will take into account the financing costs when we compute the required rate of return
(discount rate).

• So taking into account financing costs in cash flows would be double counting => Ignore them

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Summary: Cash Flows

63
Summary: Investment outlay

Start with Capital expenditure (CAPEX)

Subtract Increase in working capital
Equals Initial investment

64
Summary: After-tax operating cash flow
Start with Sales
Subtract Operating expenses
Subtract Depreciation
Equals Earnings Before Interest and Taxes (EBIT)
Subtract Taxes on EBIT
Equals Earnings Before Interest and After Taxes (EBIAT)
Plus Depreciation
Equals After-tax operating cash flow

65
Summary: Terminal year after-tax
nonoperating cash flow
Start with After-tax salvage value
Add Return of net working capital
Equals Nonoperating cash flow

66
What About Inflation?
• With inflation, the purchasing power of a given amount of money
gets smaller over time

• The amount of money is called a “nominal” cash flow

• The purchasing power of that money is called the “real” cash flow

• We usually work in nominal terms

• But it is also possible to work in real terms

67
Converting nominal to real cash flows
• If we start with a nominal cash flow C in one year, and inflation is I, then the
𝐶
real cash flow is 1+𝑖 (expressed in today’s purchasing power)

• If inflation is 3%, then $100 next year has the same purchasing power as
$97.09 this year

𝐶
• Likewise the real equivalent of any future nominal cash flow in t years is 1+𝑖 𝑡
• This formula assumes inflation growing a constant rate of i

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Converting nominal to real cash flows
• If we convert cash flows to real terms and we want to find their present
value, we must discount them by the real discount rate

• The relationship between the real discount rate (r) and the nominal
discount rate (R) is:
1+𝑅 = 1+𝑟 1+𝑖

• A convenient approximation is 𝑅 ≈ 𝑟 + 𝑖

• Example: If the interest rate is 3% and inflation is 3.5%, the real interest
rate is roughly -0.5%.

69
Inflation: Example
Imperial Polymers is considering investing $200 million this year (1992) in a plant to
produce Cyrillic fibre. Working capital required is $80 million. Revenues from each
plant are expected to be $150 million (at 1992 prices) in each year 1993 – 1996 and
operating costs are estimated at 40% of revenues. The plant will be sold in 1996 for an
estimated $50 million (in 1992 prices). The corporate tax rate is 40% and the real cost
of capital is 10%. Assume inflation is 10% a year and that tax depreciation is straight
line 25% a year

Q1. Set out the project cash flows and calculate the NPV using nominal values

Q2. Recalculate the NPV using real values.

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Inflation: Example
1992 1993 1994 1995 1996

Sales 165 182 200 220 Nominal values

Operating & launch costs -66 -73 -80 -88

Depreciation 50 50 50 50
$ value of sales, costs, net working
capital increasing with time
Operating Income 0 49 59 70 82

Non Operating Income

1 + 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 = 1 + 𝑟 ∗ 1 + 𝑖
EBIT 0 49 59 70 82
= 1 + 10% ∗ 1 + 10% = 1.21
(1) EBIT x (1-t)+depreciation 0 79 85 92 99

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝑎𝑡𝑒 = 21%

(2) Increase in NWC -80 117

Nominal values are discounted by the

Investment -200 nominal discount rate
(3) Total Capex -200

Salvage (After Tax) 43.92 Changes in NWC in 1996:

Total Cash Flow (1+2+3) -280 79 85 92 260
$80 ∗ (1 + 10%)4
NPV @ (21%) $17.1

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Inflation: Example
1992 1993 1994 1995 1996
Real values
Sales 150 150 150 150

Operating & launch costs -60 -60 -60 -60

$ value of sales, costs, net working
Depreciation 45 41 38 34
capital same over time time
Operating Income 0 45 49 52 56

Non Operating Income

Depreciation (accounting construct)
EBIT 0 45 49 52 56
will have to be adjusted by inflation
(1) EBIT x (1-t)+depreciation 0 72 71 69 68

(2) Increase in NWC -80 80

Real values are discounted by the
real discount rate
Investment -200

(3) Total Capex -200

Note that the result is the same!
Salvage (After Tax) 30.00

Total Cash Flow (1+2+3) -280 72 71 69 178

NPV @ (10%) $17.1

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So, do we use nominal or real cash flows?

In practice and in this class, we usually use nominal cash flows, since calculating
everything in real cash flows would create extra work!

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Exercise 1: Galt Motors

Galt Motors currently produces 500,000 electric motors a year and expects output levels to remain
steady in the future. It buys armatures from an outside supplier at a price of $2.50 each. The plant
manager believes that it would be cheaper to make these armatures rather than buy them. Direct in-
house production costs are estimated to be only $1.80 per armature. The necessary machinery would
cost $700,000 and would be obsolete in 10 years. This investment would be depreciated to zero for
tax purposes using a 10-year straight line depreciation. The plant manager estimates that the
operation would require additional working capital of $40,000 but argues that this sum can be ignored
since it is recoverable at the end of the ten years. The expected proceeds from scrapping the
machinery after 10 years are estimated to be $10,000. Galt Motors pays tax at a rate of 35% and has
an opportunity cost of capital of 14%.

Calculate the NPV and IRR

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Exercise 2: Turbo Widget
It is 2011. The TW concept was developed at an R&D cost of $1,000,000 incurred from 2006-
2010. Producing the TW will require the purchase of a new machine costing $2,000,000. The new
machine will last for 15 years. After 15 years it will be scrapped for $50,000. For tax purposes, the
machine can be depreciated to $0 over 10 years using the straight line method. In addition, TW’s
will be painted using 30% of currently idle capacity (70% of the capacity is already being used to
paint Regular Widgets) of an existing painting machine. The painting machine costs $30,000 per
year to operate (regardless of how much it is used). Operating costs per year are $40,000 and
sales are $400,000. Sales of Regular Widgets fall by $20,000 for t=1 to t=15 due to TW. The
opportunity cost of capital is 10%. An inventory of $200,000 is needed over the life of the project
starting at t=0. The tax rate is 40%.

Calculate the NPV of the TW project

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Conclusion

• Discount incremental cash flows – not net income

• Depreciation tax shields
• Working Capital Investments

• Remember:
• Sunk costs do not count
• Allocated costs do not count
• Ignore financing in cash flows in the WACC method

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 Thanks!
Does anyone have any questions?

dimasfazio@nus.edu.sg
BIZ 1 - #07-62