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

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

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

Cash Flow vs. Accounting Income 6

Cash Flow vs. Accounting Income 8

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

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

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

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

Inflation Example - nominal figures 15

Inflation Example - real figures 16

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

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

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.

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

Blooper Industries (,000s) 18

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

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

Web Resources http://finance.yahoo.com www.bloomberg.com http://hoovers.com www.investor.reuters.com www.cbs.marketwatch.com http://money.cnn.com http://moneycentral.msn.com www.euroland.com www.valueline.com