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INTRODUCTION TO CORPORATE FINANCE Laurence Booth • W. Sean Cleary

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1 INTRODUCTION TO CORPORATE FINANCE Laurence Booth • W. Sean Cleary
Prepared by Ken Hartviksen

2 CHAPTER 14 Cash Flow Estimation and Capital Budgeting Decisions

3 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Lecture Agenda Learning Objectives Important Terms General Guidelines for Capital Project Analysis Estimating and Discounting Cash Flows Sensitivity to Inputs Replacement Decisions Inflation and Capital Budgeting Decisions Summary and Conclusions CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

4 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Learning Objectives How to estimate the future cash flows associated with potential investments How to determine whether these investments are the result of expansion or replacement decisions How to conduct a sensitivity analysis to see how the value changes as key inputs vary Why real option valuation techniques have become an important trend in project evaluation How mistakes can easily be made in dealing with inflation CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

5 Important Chapter Terms
Capital cost (C0) Decision tree Ending (or terminal) after-tax cash flow (ECFn) Expansion projects Expected annual after-tax cash flows (CFt) Externalities Initial after-tax cash flow (CF0) Marginal or incremental cash flows NPV break-even point Opportunity costs Real option valuation (ROV) Replacement projects Salvage value (SVn) Scenario analysis Sensitivity analysis Sunk costs CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

6 Cash Flows and Capital Budgeting Introduction
Decisions are only as good as the information used to make them. This chapter focuses on approaches used to estimate future cash flows associated with capital project proposals CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

7 Project Evaluation Techniques Required Information and Estimates
All evaluation approaches (NPV, IRR, Discounted Payback, and PI) require the same data: Estimate of initial cost (CF0) Net incremental after-tax cash flows CFBT(1-T) Cost of Capital (k) Estimate of useful life (n) Ending Cash flows (ECFn) Corporate tax rate (T) Capital Cost Allowance Rate (d) This chapter provides you with guidelines for identifying relevant information and testing the decision’s sensitivities to variations in those input variables. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

8 Cash Flows Estimation General Guidelines
Cash flows should be: After-tax Incremental or marginal Do not include interest or dividends Adjust initial cash outlay and terminal cash flows for additional working capital requirements Treat sunk costs as irrelevant Opportunity costs should be factored into the cash flow estimates Determine the appropriate time horizon for the project Ignore intangible considerations Ignore externalities Consider the effect of all project interdependencies on cash flow estimates. Treat inflation consistently Undertake all social investments required by law. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

9 The Capital Budgeting Cash Flows The Basic Cash Flow Pattern
The following slide graphically illustrates the basic cash flow patterns involved in a capital project: There is an initial investment at t = 0 (CF0 ) There follows an annual stream of after-tax cash flow benefits (CF t ) At the end of the useful life, ending cash flow benefits after tax are received (ECF n ) [ 14-5] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

10 The Capital Budgeting Cash Flows The Basic Cash Flow Pattern
Initial After-Tax Cash Flow (CF0) If CF 0 < PV of CFt , then benefits exceeds costs, the NPV is positive. ACCEPT the Project t=1 2 3 n-1 n CF1 CF2 CF3 CFN-1 CFN Expected Annual After-Tax Operating Cash Flows (CF tt) Terminal Cash Flow (ECFn) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

11 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern The basic cash flow pattern can be deconstructed into: Initial investment (CF0 ) Annual stream of after-tax cash flows throughout the project life (CF t ) Ending cash flows (ECF n ) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

12 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern CF 0 There is an initial investment at t = 0 (CF0 ) consists of: C 0 the initial capital cost of the asset ΔNWC0 the change in net working capital OC the opportunity costs associated with the project [ 14-1] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

13 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern CFt There follows an annual stream of after tax cash flow benefits (CF t ) consisting of: Operating after-tax cash flow benefits (OCF t ) = CFBTt (1 – T) Tax shield benefits from CCA [ 14-2] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

14 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern ECFn At the end of the useful life, ending cash flow benefits received (ECF n ) in the absence of tax issues include: SV n the estimated salvage value in year n for the asset purchased ΔNWC n the net working capital investment released at the end of the project [ 14-4] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

15 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern ECFn If there are tax issues the ECF n consists of: SV n the estimated salvage value in year n for the asset purchased ΔNWC n the net working capital investment released at the end of the project Less any taxes payable on the salvage value (capital gains, recapture of depreciation) [ 14-3] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

16 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
The Capital Budgeting Cash Flows Deconstructing the Basic Cash Flow Pattern Putting It All Together Once you have estimated the cash flows you must: Determine their after-tax values Discount them back to the present Sum them in determining the NPV (The following slide graphically illustrates the deconstructed cash flow pattern involved in a capital project) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

17 The Capital Budgeting Cash Flows Deconstructing the Cash Flows
Initial After-Tax Cash Flow (CF0) Because the CCA tax shield benefit changes each year in a predictable fashion, we can use a formula to calculate their total present value. CF0 = C0 +Δ NWC0 + OC t=1 2 3 n-1 n CF1 CF2 CF3 CFN-1 CFN Expected Annual After-Tax Operating Cash Flows (excluding CCA Tax Shield) (OCFt) = CFBT(1 – T) Terminal Cash Flow (ECFn) Expected Tax Shield Benefits from CCA deduction (CdT) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

18 Alternative Approaches to Finding the Tax Shield Benefit on CCA
You will recall that there are two approaches to determining cash flows. We will use alternative (2) found on Table 14-1 This allows us to deconstruct the analysis, separating operating cash flows from the tax shield benefits of CCA. (See the following slide) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

19 Determining Cash Flows after CCA
CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

20 Separating Operating Cash Flows from CCA Tax Shield Benefits
t=1 2 3 n-1 n CF1 CF2 CF3 CFN-1 CFN Typically operating cash flow benefits can be treated as an annuity. The CCA Tax Shield benefits are a growing perpetuity with a constant negative growth rate. The only exception to this is the first cash flow. (This is ½ year rule effect.) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

21 Tax Shield Benefit of CCA
The tax shield benefit from CCA is equal to the corporate tax rate (T) × CCA amount. As demonstrated in the following slide, assuming the firm will have taxable operating income in the future, we can predict the maximum amount of CCA the firm can claim from the year of acquisition through to infinity. You will note: ½ rule effect in the first year We assume we claim the maximum CCA in each subsequent year. We forecast the tax shield benefit by: T× CCAt Tax shield benefits will be a perpetual stream of cash flows that are going a constant negative compound growth rate (d) where d is the CCA rate CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

22 CCA Tax Shield Over Time (Assume a corporate Tax Rate ‘T’ of 40%)
$100,000 asset is acquired in year 1. No asset pool disposals. CCA rate (d) = 10% Tax Shield = T(CCA) Lets graph this series of tax shield benefits the firm is forecast to receive. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions 9

23 CCA Tax Shield Over Time (A Graphical Representation)
Asymptotic Curve CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions 10

24 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Observations In the foregoing you can now readily see: CCA provides large tax shields in the early years of the asset’s life residual values remain in the pool long after the asset was acquired…this means that the firm will never fully recoup the original cost of the asset … as the firm’s asset base ages, cash flows generated from CCA will not enable the firm to replace the original asset. Now we can learn how to find the present value of a perpetual stream of forecast cash flows. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions 11

25 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Present Value of the CCA Tax Shield (Assume a corporate Tax Rate ‘T’ of 40% and Discount rate of 12%) Multiplying T(CCA) by the PVIF we can estimate the present value of the tax shield benefit for each year into the future. This is the sum of the first 8 years of tax savings…it would be an infinitely long process to find the actual sum of an infinite stream of cash flows. We must develop a formula-based solution to this problem. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions 9

26 Present Value of the CCA Tax Shield
In Chapter 7 you learned about the constant growth DDM: This model assumes the first dividend becomes the base amount and all future cash flows grow at a constant compound rate from t =1 through infinity: [ 7-7] [ 7-6] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

27 Present Value of the CCA Tax Shield
The constant growth DDM: The Tax Shield benefit to CCA (ignoring the ½ year rule for a moment) is the same except: Cash flow at time one is the CCA tax shield at t = 1 and is calculated as (TdC0) – this is the numerator The growth is negative (declining balance) – two negatives equal a positive! CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

28 Present Value of Tax Savings Lost on Salvage Value – an ECF
We will use this version of the formula to calculate the present value of tax savings lost on the salvage value of the asset (when the ½ net addition rule does not apply) The PV of tax savings lost at time n = CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

29 Present Value of Tax Savings Lost on Salvage Value – an ECF
The PV of tax savings lost at time n = The last step in finding the Present value of this amount is to discount the value back to t = 0. So…the equation becomes: CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

30 Present Value of the Tax Savings on CCA Assuming the ½ Year Rule
Adjusting the Formula for the ½ year Net Addition Rule We multiply the first factor by (1+.5k) / (1+ k) to produce a formula that will estimate the present value of tax savings from CCA (time 1 through infinity) assuming ½ year net addition rule. For a graphical depiction of this formula see the following slide. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

31 CCA Tax Shield Over Time (A Graphical Representation)
This formula calculations the PV of tax savings on CCA from time 1 through infinity assuming the ½ year net addition rule. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions 10

32 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Present Value of the Tax Savings on CCA Adjusting for ½ Year Rule – An Example We can now use the formula to solve for the present of the tax savings on CCA for an asset that is never sold (no salvage value): This formula assumes: C0 = $100, (Initial cost of a depreciable asset) d = 10% (CCA rate) k = 12% (Cost of capital or discount rate) T = 40% (Corporate tax rate) Notice the answer is greater than the spread sheet example ($13,871) because the spreadsheet summed only the first 8 cash flows whereas the formula finds the sum of the present values of the tax shield benefits for an infinite stream. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

33 Formula for PV of Tax Savings on CCA Assuming a Salvage Value at t = n
Finally we can incorporate planned disposal of the asset we will acquire. Disposal value is the ‘salvage value’ (SV) at t = n (See the following two slides for graphical depiction of the effect of a salvage value) [ 14-7] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

34 CCA Tax Shield Over Time (A Graphical Representation)
By selling the asset after the end of the 10th fiscal year, we lose CCA in years 11 through infinity. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions 10

35 CCA Tax Shield Over Time (A Graphical Representation)
We subtract the PV of tax savings lost on the Salvage Value from the PV of tax saving from t = 1 through infinity to get the PV of tax savings benefits years 1 – 10. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions 10

36 Expected Annual After-Tax Cash Flows (CFt)
As illustrated in Equation 14-2 expected Annual After-Tax Cash Flows are: The cash flows that are estimated to occur as a result of the investment decision, comprising the associated expected incremental increase in after-tax operating income and Any incremental tax savings (or additional taxes paid) that result from the initial investment outlay. [ 14-2] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

37 Forecasting Expected Annual After-Tax Cash Flows (CFt)
Spreadsheets can be useful in making detailed forecasts of the incremental operating cost and benefits associated with the project. Operating cash flows are an annuity where as net cash flow is not. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

38 Decomposing Expected Annual After-Tax Cash Flows (CFt)
We have already seen that since the CCA tax shield (CCAt)(T) changes each year and potentially involve an infinite series, we separately calculate its present value using a formula. [ 14-2] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

39 Decomposing Expected Annual After-Tax Cash Flows (CFt)
Since the operating cash flow benefits after-tax are often equal each year, we can find their present value simply using the Present Value Factor of an Annuity: [ 14-6] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

40 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Decomposing Expected Annual After-Tax Cash Flows (CFt) Example of the PV of the Operating Cash Flow Annuity Using Example 14 – 2: Operating income excluding CCA before tax = $125,000 Tax rate = 45% Useful life = 5 years Discount rate (k) = 10% The present vale of the operating income annuity = CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

41 Ending (or Terminal) After-Tax Cash Flows (ECFn)
Ending cash flows include: Salvage value of the asset (SVn) Recovery of the net investment in working capital (NWCn) Less any taxes payable in the event of a capital gain on the sale of the asset or a recapture of depreciation. [ 14-3] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

42 CCA Tax Shield with a Recapture of Depreciation
Equation Is used when the salvage value of the asset is greater than the UCC of the pool of assets at the time of disposal. A recapture of depreciation must be included in income in the year it occurs and is subject to tax at the firm’s tax rate (T ) [ 14-8] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

43 Capital Gain on Asset Disposal
Equation 14 – 9 is used when you expect to sell the asset for a price that is greater than its original cost. The difference between the SV and C0 is the capital gain. 50% of a realized capital gain is subject to tax at the corporate tax rate (T ) [ 14-9] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

44 NPV Using the Decomposed Components
Equation 14-10, on the following slides, shows how the decomposed components are recombined to determine the projects NPV Remember NPV = Present value of after-tax operating cash flows Present value of CCA tax shield Present value of the salvage value (ECF) Present value of the recovery of net working capital investment (ECF) Taxes payable on realized capital gain and/or recapture of depreciation (ECF) Initial investment in the asset (CF0) Initial investment in net working capital (CF0) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

45 NPV Using the Decomposed Components
[ 14-10] CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

46 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Sensitivity to Inputs Stress testing NPV models to determine the sensitivity of the decision to input variables is an important part of risk assessment There are two common approaches: Sensitivity analysis – an examination of how an investment’s NPV changes as the value of one input at a time is changed Scenario analysis – an examination of how an investment’s NPV changes in response to varying scenarios in terms of one or more estimates, such as sales or costs CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

47 Sensitivity to Inputs Scenario Analysis
Input variables are often given discrete forecast ranges: Best case Most likely Worst case The analyst will be interested in what the NPV might be in the worst combination of cases for example: Worst case operating cash flows (low) Worst case initial cost (high) Worst case new working capital investment (high) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

48 Sensitivity to Inputs Real Option Valuation (ROV)
ROV and decision tree analysis have dramatically increased understanding of corporate decision-making and the value of flexibility and strategic considerations. Decision trees are a schematic way to represent alternative decisions and the possible outcomes. Table 14-2 (next slide) gives a real options example of three alternative ore-price scenarios for a mine. (The most important variable in mining projects.) This table illustrates that the highest expected cash flows occur when ore prices are most volatile (have the greatest range of prices). This illustrates an option that is often overlooked in traditional project analysis…the possibility of shutting down the mine when prices make it uneconomic. (Remember, the mine can be returned to production when economic conditions turn more favourable.) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

49 Real Option Valuation (ROV) Comparing NPV and IRR
CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

50 Sensitivity to Inputs NPV Break-Even Analysis
Operating Cash Flow NPV Break-even Point Solving for the annual operating after-tax cash flows that cause NPV = 0. PV (Operating CFs) is the source of value creation The most important part of the viability analysis. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

51 Sensitivity to Inputs Operating Cash Flow NPV Break-Even Point
Example: CF0 = $100,000 PV(CCA Tax Shield) = $20,453 PV(ECFn) = $12,834 Approach: Set NPV = 0 and solve for the PV of the operating CFs: Now solve for the annual after-tax CF Conclusion: The operating cash flows could fall to $10,770 without destroying value. Now the decision makers can assess the threats to this key forecast and determine the likelihood of this occurring. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

52 Sensitivity to Inputs Operating Cash Flow NPV Break-Even Point
$ $20,000 It is possible to vary the cash flow assumptions and test the sensitivity of NPV to those changes. NPV is the dependent variable. $50,000 $40,000 $30,000 $20,000 $10,000 $0 Break-even cash flow Operating Cash Flow CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

53 Sensitivity to Inputs NPV Break-Even Discount Rate
IRR of the project NPV profile illustrates the range of discount rates that produce a positive NPV. (See the following two slides as a review of NPV profiles from Chapter 13) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

54 Sensitivity to Inputs NPV Break-Even Discount Rate
$ $260,000 Discount Rate (%) IRR = 55.8% 0% 5% 10% 20% 40% 50% 60% Required rates of return can change if: The general level of interest rates rise in the economy, or The risk of the project increases. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

55 Sensitivity to Inputs NPV Break-Even Discount Rate
$ $260,000 $146,684 Discount Rate (%) IRR = 55.8% 0% 5% 10% 20% 40% 50% 60% Even if your estimate of the project’s required return (RADR) is wrong, the project’s NPV remains positive over a wide range of values for k (from 0% to 55%) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

56 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Expansion Decisions Expansion projects add something extra to the firm in terms of sales or cost savings; their new cash flows are incremental cash flows CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

57 Replacement Decisions
Involve the replacement of an existing asset (or assets) with a new one. In such cases we must clearly identify the incremental cash flows paying particular attention to: The effect on the incremental capital cost (∆C0) The effect on the CCA tax shield CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

58 Replacement Decisions Incremental Capital Cost
Incremental Capital Cost (∆C0) = the difference between the purchase price of the new equipment and the salvage price of the old machine. The equipment to be replaced is normally sold. Normally there are no tax consequences on disposal, except when assets are sold at a price greater than their original cost (which triggers capital gains taxes on the difference) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

59 Replacement Decisions Effects on Capital Cost Allowance Tax Shield
When an asset is removed from the Capital Cost Allowance Class: There is no CCA in the year of disposal The UCC of the pool/class is reduced by the disposal value When an asset is added to the Capital Cost Allowance Class: There is ½ of the normal CCA on the ‘net additions to the pool’ in that year The UCC of the pool is increased by half of the net addition in the first year, and half of the net additions in the second year In replacement decisions we must modify the PV of Tax Shield formula to account for the change (∆) in C0 and (∆) in SV (See the following slide for the new formula) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

60 Replacement Decisions Effects on Capital Cost Allowance Tax Shield
The replacement of old with new results in a change in the tax shield and affects both the net cost of the new as well as the salvage value. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

61 Replacement Decisions Simple Example Ignoring CCA – Formula Approach
Incremental capital cost is the price of the new machine less the price of the old. Problem: Cost of new machine = $12,000 Disposal value of old machine = $2,000 After-tax cash flow benefits: Year 1 = $5,000 Year 2 = $5,000 Year 3 = $8,000 Discount rate (k) = 15% CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

62 Replacement Decisions Simple Example Ignoring CCA – Formula Approach
Problem: Cost of new machine = $12,000 Disposal value of old machine = $2,000 After-tax cash flow benefits: Year 1 = $5,000 Year 2 = $5,000 Year 3 = $8,000 Discount rate (k) = 15% CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

63 Replacement Decisions The Formula Approach
The deconstructed NPV model can be used in replacement decisions. Again, in replacement decisions, the focus in on the net change in operating cash flows, net change in CCA tax shield, and net changes in ending and initial cash flows. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

64 Inflation and Capital Budgeting Decisions The Impact of Inflation
Even small rates of inflation over time can have considerable effects on the economic viability of a project. Although inflation is often measured by aggregate changes in prices at the retail (CPI consumer price index) or wholesale level, these measures often do not reflect price changes specific to one company or one project. Inflation MUST be treated consistently in our project evaluation models (NPV, IRR, PI) CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

65 Inflation and Capital Budgeting Decisions Two Basic Approaches
Inflation can be consistently incorporated by: Removing it from the nominal discount rate and using nominal cash flow forecasts Leaving the discount rate with an expected inflation component and estimating real (inflation-adjusted) cash flows CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

66 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Inflation and Capital Budgeting Decisions Removing Expected Inflation from the Discount Rate As illustrated on the following slide, all discount rates used have embedded into them an expected rate of inflation. If we use non-inflation adjusted cash flow forecasts, and then discount using a nominal discount rate, we are ‘over discounting’ because we are using a higher rate…but not using inflated forecast cash flows. You can use the Fisher equation to estimate the embedded inflationary expectations, and then reduce the nominal discount rate by that amount. Then you are free to discount nominal cash flows. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

67 Risk Adjusted Discount Rates Using the CAPM
βMarket = 1 Required Return RF β M ERM βProject = 1.5 ERProject Risk Premium for project systematic risk Real rate of return Premium for expected inflation CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

68 Required Rates of Return (RADR) Components
The risk-free rate is equal to the real rate of return plus expected inflation (Fisher Equation) The risk premium is based on an estimate of the risk associated with the project. Beta of the Project Required Return (%) RF Risk Risk Adjusted Discount Rate Risk Premium Real Return Expected Inflation Rate CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

69 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Inflation and Capital Budgeting Decisions The Inflation Adjustment Process The key thing to remember is: If you use WACC unadjusted, then you must use inflation-adjusted cash flow estimates for operating cash flows If you remove inflation from the discount rate (WACC), you can use nominal cash flow estimates The key is consistency. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

70 Summary and Conclusions
In this chapter you have learned: Several approaches and guidelines for estimating future cash flows associated with an investment The equations used to estimate the present value of future cash flows How to differentiate between expansion and replacement decisions How to use sensitivity analysis, scenario analysis, what-if decision tree analysis and NPV break-even analysis. How to incorporate inflation into capital budgeting analysis. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions

71 CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions
Copyright Copyright © 2007 John Wiley & Sons Canada, Ltd. All rights reserved. Reproduction or translation of this work beyond that permitted by Access Copyright (the Canadian copyright licensing agency) is unlawful. Requests for further information should be addressed to the Permissions Department, John Wiley & Sons Canada, Ltd. The purchaser may make back-up copies for his or her own use only and not for distribution or resale. The author and the publisher assume no responsibility for errors, omissions, or damages caused by the use of these files or programs or from the use of the information contained herein. CHAPTER 14 – Cash Flow Estimation and Capital Budgeting Decisions


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