Using Discounted Cash Flows to Make Investment Decisions Chapter 9 Brealey-Myers-Marcus 6th Edition Business Finance 620 Topics Covered Pulls together many of the important ideas surrounding investment project analysis: Identifying relevant cash flows Depreciating assets with MACRS Handling inflation Choosing an appropriate cost of capital Discounting relevant cash flows (not income) Calculating and interpreting NPV and IRR Deciding whether to launch a project Case Application – PGA New Venture 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 two years. The project will produce 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 NPV using cash flow to the NPV using accounting income. Cash Flow vs. Accounting Income Discounting Accounting Income Cash Flow vs. Accounting Income Discounting Cash Flow Incremental Cash Flows Discount incremental cash flows Include all indirect effects Forget sunk costs Include opportunity costs Remember the investment in working capital Beware of allocated overhead costs Net Working Capital Investment Investment in inventories and receivables: Should be included in incremental cash flows. Common problems in project development: Neglecting working capital Forgetting that working capital requirements can change over the life of a project Forgetting that the working capital investment is recovered by the end of the project Modified Accelerated Cost Recovery Recovery Class Period Equipment is assigned a recovery class and then depreciated. The half-year convention (see 5-year schedule): Assume the asset is purchased at mid-year of Year 1 and provides 5 years of service (through mid-year of Year 6). Inflation and Capital Budgeting INFLATION RULE Be consistent in handling inflation!! Discount nominal cash flows with nominal rates. Discount real cash flows with real rates. You will get the same results, whether you use nominal or real figures. The PGA New Venture Problem The PGA Corporation plans to launch a set of commemorative golf club covers. Expected revenues from the project are shown below. Expenses will run 25% of revenues, with working capital required each year set to 15% of revenues in the following year. The project has the following expected revenues: Year 1: $293,000 Year 2: $367,000 Year 3: $448,000 Year 4: $507,000 Year 5: $428,000 The project will be discontinued at the end of Year 5. A new building must be acquired at the start of the project at a total cost of $936,800. The facility is to be depreciated straight-line over five years to a salvage value of zero, but management has agreed to sell it for $163,000 at the end of the project. If PGA’s cost of capital is 14.75%, and its tax rate is 35%, what is the project’s NPV? Should the company launch the venture? Components of a Project Pro-Forma The pro-forma organizes a project’s financial information. Project investment Strategic assets (tangible and intangible) Working capital requirements Project operation Cash flow from operations and net cash flow Adjustments to project assets and working capital Project completion Cash flow from the recovery of working capital Cash flow from the sale or transfer of project assets The PGA Project Pro-Forma Figures in dollars unless otherwise indicated. Net Working Capital Investment Today Year 1 Year 2 WC investment (43,950) (11,100) Working capital 43,950 55,050 Revenue 293,000 367,000 The working capital investment must be in place at the start of the year for which the funds are required. Components of After-Tax Cash Flow REVENUE – Operating expenses (cash expenses only) – Income taxes paid = Net cash flow from operations – Net working capital investment (excess of new investment over recovered funds) – Net capital investment (excess of purchase amounts over sale proceeds) = AFTER-TAX CASH FLOW After-Tax Cash Flow for Year 2 Revenue 367,000 – Operating expenses 91,750 – Income taxes paid 30,762 – Net working capital investment 12,150 – Net capital investment 0 = AFTER-TAX CASH FLOW 232,338 The following table shows the relation between project revenue in Year 2 and project after-tax cash flow. Cash Flow from Asset Sale PGA New Venture Analysis NPV @ 14.75% = ($39,710) and IRR = 13.25% Do not launch the project.