1. Chapter 9 Fundamentals of Corporate Finance
Sixth Edition
Richard A. Brealey
Stewart C. Myers
Alan J. Marcus
Chapter 9
Using Discounted Cash Flow Analysis to Make Investment Decisions
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved

2. Topics Covered Identifying Cash Flows Calculating Cash Flows
Discount Cash Flows, Not Profits
Discount Incremental Cash Flows
Discount Nominal Cash Flows by the Nominal Cost of Capitol
Separate Investment & Financing Decisions
Calculating Cash Flows
Example: Blooper Industries 2

3. Cash Flow vs. Accounting Income
Discount actual cash flows
Using accounting income, rather than cash flow, could lead to erroneous decisions.
Example
A project costs $2,000 and is expected to last 2 years, producing cash income of $1,500 and $500 respectively. The cost of the project can be depreciated at $1,000 per year. Given a 10% required return, compare the NPV using cash flow to the NPV using accounting income. 4

4. Cash Flow vs. Accounting Income6

5. Cash Flow vs. Accounting Income8

6. Incremental Cash Flows
Discount incremental cash flows
Include All Indirect Effects
Forget Sunk Costs
Include Opportunity Costs
Recognize the Investment in Working Capital
Beware of Allocated Overhead Costs
Remember Shutdown Cash Flows
Incremental Cash Flow
cash flow with project
cash flow without project = - 9

7. Incremental Cash Flows
IMPORTANT
Ask yourself this question
Would the cash flow still exist if the project does not exist?
If yes, do not include it in your analysis.
If no, include it. 11

8. Inflation INFLATION RULE Be consistent in how you handle inflation!!
Use nominal interest rates to discount nominal cash flows.
Use real interest rates to discount real cash flows.
You will get the same results, whether you use nominal or real figures 12

9. Inflation
Example
You own a lease that will cost you $8,000 next year, increasing at 3% a year (the forecasted inflation rate) for 3 additional years (4 years total). If discount rates are 10% what is the present value cost of the lease? 14

10. Inflation
Example - nominal figures 15

11. Inflation
Example - real figures 16

12. Separation of Investment & Financing Decisions
When valuing a project, ignore how the project is financed.
Following the logic from incremental analysis ask yourself the following question: Is the project existence dependent on the financing? If no, you must separate financing and investment decisions. 17

13. Calculating Cash Flows
Think of cash flows as coming from three elements
Total cash flow =
+ cash flows from capital investments
+ cash flows from changes in working capital + operating cash flows

14. Calculating Cash Flows
Cash Flow from Capital Investments
Almost every project requires some sort of initial investment. This is often capitalized from an accounting perspective. In finance, the investment represents a negative cash flow.

15. Calculating Cash Flows
Operating Cash Flow
Operating cash flow =
+ Revenue
- Costs
- Taxes
Methods of Handling Depreciation
Method l: Dollars in Minus Dollars Out
Method 2: Adjusted Accounting Profits
Method 3: Add Back Depreciation Tax Shield

16. Blooper Industries
(,000s) 18

17. Blooper Industries
Cash Flow From Operations (,000s)
or $3,950,000 19

18. Blooper Industries Net Cash Flow (entire project) (,000s)
12% = $4,222,350 20

19. Web Resources http://finance.yahoo.com www.bloomberg.com