SESSION 4:

FREE CASH FLOW AND NET

PRESENT VALUE

N. K. Chidambaran
Corporate Finance
 Agenda

 Estimating a project’s after-tax incremental

free cash flows
 Computing the Net Present Value (NPV) of a
project
 Choosing between mutually exclusive projects
 Comparing projects with unequal lives

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Investment Decisions Under Uncertainty - Project
Evaluation
  
 Net Present Value (NPV) = Value – Cost

where:

If NPV > 0, then “ACCEPT” the project

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 Project Evaluation

Thus, to compute value of the project to the firm,

we need to:

(i)Forecast the future stream of expected cash

flows (“relevant” or “incremental”)

(ii) Estimate the required rate of return

commensurate with the risk of the cash flows

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“Relevant” or “Incremental” Cash Flows

Incremental Cash Flows =

Cash flows of the firm with the project

less

Cash flows of the firm without the project

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 Stand-Alone Principle

 Once we have identified the “relevant” or

“incremental” cash flows from a project, we
can treat it as a mini-firm with its own cash
flows, assets, and liabilities

 As such, we can use the same valuation

methodology to value a project or an entire
firm

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 Identifying Project Cash Flows
Which of these items is a “relevant” or
“incremental” cash flow for a project?
1. Sunk costs
2. Opportunity cost
3. Side effects
4. Depreciation
5. Transfer pricing
6. Allocated overheads
7. Investment in working capital
8. Financing costs
9. Taxes
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 Identifying Incremental Cash Flows (Continue)

Determine which of the following is a relevant cash flow and which is not relevant for
capital budgeting purposes. Also, where appropriate, determine whether the item is a
sunk cost or an opportunity cost.

 a. The building will be built on land already owned by the company with a market
value of $2 million. If the company does not accept the project, the land will be
sold for $2 million.

 b. $100,000 in preliminary grading work has been done to prepare the site.

 c. The building will cost $10.5 million, and equipment will cost $4.5 million.

 d. The company paid a $1 million royalty to obtain rights to a production process.

 e. Additional royalty payments of 1% of gross revenues from the product will be

required.

 f. Last year the company signed a non-cancelable 10-year lease on the building,
requiring payments of $150,000 per year.

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 Identifying Incremental Cash Flows
(Continued)
 g. The product is expected to generate sales of $2 million per year.
Of these sales, 7% are expected to come from existing products,
30% are expected to come from a major competitor, and the rest
will be entirely new sales to the industry.

 h. The plant and equipment will be depreciated for tax purposes on a

straight-line basis to zero salvage value over a 10-year period. The
tax rate is 36%.

 i. The variable costs of production will be $500,000 per year.

 j. Accounting plans to allocate supervisory and management costs of

$25,000 per year to the project. No new supervisory or management
personnel will be required.

 k. Accounting plans to allocate electricity costs of $1,000 per month

to the project due to the energy demands of the new equipment.
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Identifying Incremental Cash Flows (Continued)

 l. The inventor of the product left the company last year. She will
receive non-compete payments of $50,000 per year for the
next three years.

 m. The project will require additional working capital of $2

million. The working capital can be recovered at the end of
the life of the project.

 n. The plant and equipment are expected to last for 15 years,

at which time it is expected that they can be sold for $3.5
million.

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 Operating Cash Flow (OCFt)

Let Rt = Revenues
Ct = Costs
Dt = Depreciation expense
T = Corporate marginal tax rate

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Operating Cash Flow (OCFt)
(Continued)

OCFt = Unlevered Net Incomet + Dt

= (Rt – Ct –Dt)(1 – T) + Dt

OR

OCFt = (Rt – Ct)(1 – T) – Dt(1 – T) + Dt

Thus, OCFt = (Rt – Ct) (1 – T) + DtT

Where DtT = Depreciation tax shield

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 Free Cash Flow (FCFt)

Free Cash Flow (FCFt)

FCFt = OCFt - ∆NWCt- NCSt

Where:

NCSt = Net capital spendingt = Assets boughtt – Assets

soldt
∆NWCt = Change in NWCt = NWCt – NWCt-1

Note: NWC = Current assets (CA) – Non-interest

bearing current liabilities (NIBCL) [in a valuation
framework]
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 Depreciation Expense, Dt

Straight line depreciation (SLD):

Dt = (Cost – Salvage Value)/Life

Modified Accelerated Cost Recovery System (MACRS) [US]:

(i) Identify the recovery period applicable to that asset

(ii)Use the depreciation rate as per the schedule for that recovery period

Dt = Depreciation ratet x Cost

Written Down Value (WDV) Method [India]:

(i) Identify the depreciation rate applicable to that asset block

(ii) Apply that depreciation rate to the beginning book value each period

Dt = Depreciation rate for asset block x Beginning book valuet

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 Sale of Asset

After-tax cash flow from asset sale =

Sale price – (T x Capital gain)

Where:

Capital gain = Sale price – Book value

and
Book Value = Cost– Accumulated depreciation

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 Capital budgeting problem

 Problem:

 You are given the responsibility of conducting

the project selection analysis in your firm. You
have to calculate the NPV of a given project.
The appropriate cost of capital is 12 percent
and the firm is in the 30 percent tax bracket.
You are provided the following pieces of
information regarding the project:

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 Details

 The project is going to be built on a piece of

land that the firm already owns. The market
value of the land is $1 million. The land can be
sold at the end of year 10 for $1 million.
 If the project is undertaken, prior to
construction, an amount of $100,000 would
have to be spent to make the land usable for
construction purposes.
 In order to come up with the project concept,
the company had hired a marketing research
firm for $200,000.
 The firm has spent another $250,000 on R&D
for this project.
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 Details

5. The project will require an initial outlay of $20

million for plant and machinery.
6. The sales from this project will be $15 million
per year of which 20 percent will be from lost
sales of existing products.
7. The variable costs of manufacturing for this
incremental level of sales will be $9 million per
year.
8. The company uses straight-line depreciation.
The project has an economic life of ten years
and will have a salvage value of $3 million at
the end.

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 Details

9. Because of the project the company will need

additional working capital of $1 million today
which can be liquidated at the end of ten years.
10.The project will require additional supervisory
and managerial manpower that will cost
$200,000 per year.
11.The accounting department has allocated
$350,000 as allocated overhead cost for
supervisory and managerial salaries.

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 Calculate initial cost

 Initial cost is the sum of:

 Market value of land: $1 mil (opportunity cost)
 Land improvement $100 k
 Plant & machinery: $20 mil
 Incremental working capital: $1 mil

Initial cost
= 1,000,000 + 100,000 + 20,000,000 + 1,000,000
= $22,100,000

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 Calculate the annual incremental cash
flow: step 1
 Calculate the annual depreciation expense
For this project, fixed assets refer to $20mil plant
& machinery. Therefore,

 Depreciation
= (20,000,000 – 3,000,000)/10
= $1,700,000

 Calculate incremental sales

Incremental sales = 0.8 x 15,000,000
= $12,000,000
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Calculate the annual incremental cash flow: step 2

Draw up the incremental income statement

Incremental sales 12,000,000
Less Incremental variable cost 9,000,000
Less Incremental managerial salaries 200,000
Less Incremental depreciation 1,700,000
Equals Incremental taxable income 1,100,000
Less Incremental tax @30% 330,000
Equals Incremental net income 770,000
Add back depreciation 1,700,000
Incremental operating cash flow $2,470,000 22
 Consider other cash flows

 At the end of project’s life (t=10),

company
 Recovers $1 mil additional working capital (item
9)
 Receives $3 mil salvage value from plant &
machinery (item 8)
 Sell land for $1 million

Additional cash flows at end of project

= 1,000,000 + 3,000,000 + 1,000,000
= $5,000,000 23
Let’s bring all the cash flows together 1
 Initial cost = $22,100,000

 Annual incremental operating after-tax cash flow

(Year 1 through Year 10) = $2,470,000 = OCF1-
10

 FCF1-9 = OCF1-10 = $2,470,000

 Additional cash flow in Year 10 = $5,000,000

 So, in year 10, the company receives a total of
= 2,470,000 + 5,000,000 = $7,470,000 = FCF10

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Let’s bring all the cash flows together 2

Initial investment = -$22,100,000

FCF for Years 1 - 9 = OCF for Years 1 - 9: $2,470,000
FCF for Year 10 = $7,470,000

NPV = 2,470,000 x PVIFA12%, 9 + 7,470,000 x PVIF12%, 10

- 22,100,000

NPV = -$6,534,082.93

Decision: Reject the project.

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 Mutually Exclusive Projects

 Projects are mutually exclusive if accepting one

implies that the other projects will be foregone.

 When projects are mutually exclusive and have

equal lives, you have to
 rank the projects based on their NPVs
 choose the best project, provided the
project’s NPV is positive

 With mutually exclusive projects,

choosing the project with the highest NPV
is always correct.
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