my chap 009
TRANSCRIPT
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Fundamentals
of Corporate
Finance
Sixth Edition
Richard A. BrealeyStewart C. Myers
Alan J. Marcus
Chapter 9
McGraw Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved
Using Discounted Cash Flow
Analysis to Make Investment
Decisions
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Topics Covered
Identifying Cash Flows
Discount Cash Flows, Not Profits
Discount Incremental Cash Flows
Discount Nominal Cash Flows by the NominalCost of Capitol
Separate Investment & Financing Decisions
Calculating Cash Flows
Example: Blooper Industries
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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 bedepreciated at $1,000 per year. Given a 10% required
return, compare the NPV using cash flow to the NPV
using accounting income.
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500-500+IncomeAccounting
$1,000-$1,000-onDepreciati
500$$1,500InflowCash
2Year1Year
32.41$)10.1(
500
1.10
500
=NPVApparent 2 !
Cash Flow vs. Accounting Income
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5001,
500+2,
000-loashree
2,000-ostProject
500$$1,500In loash
2ear1earToday
14.223$)10.1(
500
)10.1(
500,12,000=NPVCash2
!
Cash Flow vs. Accounting Income
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Relevant Cash Flows
The cash flows that should be included in acapital budgeting analysis are those that will
only occur if the pro ect is accepted
These cash flows are called incrementalcash flows
Thestand-alone principle allows us to
analyze each pro ect in isolation from the
firm simply by focusing on incremental cash
flows
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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 pro ect
cash flow
without pro ect= -
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Incremental Cash Flows
IMPORTANTIMPORTANT
Ask yourself this question
Would the cash flow still exist if the pro ect
does not exist?
If yes, do not include it in your analysis.
If no, include it.
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Inflation
INFLATION RULEINFLATION 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 youuse nominal or real figures
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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?
1 real interest rate =1+nominal interest rate
1+inflation rate
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Inflation
Example - nominal figures
$29,0736,
5688,
742
=8
000x1.
033
7,014487,8=8000x1.032
491,78,240=8000x1.031
00.000,880000
10%@PVFloCashear
3
2
10.1
8742310.1
8487210.1
8240
!
!
!
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Inflation
Example - real figures
29,073
6,5688,0003
7,0148,0002
7,4918,00018,
0008,
0000
PV 6.7961%FlowCashYear
3
2
068.1
8,000068.1
8,000068.1
8,000
= $
!
!
!
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9- 14 Separation of Investment &Financing Decisions
When valuing a pro ect, ignore how the
pro ect is financed.
Following the logic
from incrementalanalysis ask yourself the following
question:Is the project existence dependent
on the financing? If no, you must separate
financing and investment decisions.
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Calculating Cash Flows
Think ofcash flows ascoming from threeelements
Total cash flow =
+ cash flows from capital investments
+ cash flows from changes in working capital
+ operating cash flows
Operating cash flows = 1) Net income + depreciation if theres
no interest expense or
2) EBIT + depreciation taxes or
3) (Sales costs) (1-tax rate)+ Depreciation *Tax rate = > Tax
Shield approach: this last form is particularly useful when
purchasing equipment
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More on NWC
Why do we have to considerchanges in NWCseparately? GAAP requires that sales be recorded on the income
statement when made, not when cash is received
GAAP also requires that we record cost of goodssoldwhen the corresponding sales are made, regardless ofwhen we actually pay oursuppliers
So,cash flow timing differences exist between thepurchase of inventory, revenue and costs from itssale on
the income statement, and the actual cash collection fromitssale
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Depreciation
The depreciation expense used forcapitalbudgeting should be the depreciationschedule required by the IRS for tax
purposes
Depreciation itself is a non-cash expense;consequently, it is only relevant because itaffects taxes
Depreciation tax shield = DxT D = depreciation expense
T = marginal tax rate
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Computing Depreciation
Straight-line depreciation D = (Initial cost salvage) / number of years
Very few assets are depreciated straight-line for taxpurposes
MACRS Need to know which asset class is appropriate for tax
purposes
Multiply percentage given in table by the initial cost
Depreciate to zero Mid-yearconvention
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After Tax Salvage
If the salvage value is different from the bookvalue of the asset, then there is a tax effect
Book value = initial cost accumulated
depreciation After tax salvage = salvage T(salvage
book value)
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9- 20 Example: Depreciation and After-Tax
Salvage
You purchase equipment for $100,000 and itcosts $10,000 to have it delivered and installed.
Based on past information, you believe that you
can sell the equipment for $17,000 when you are
done with it in 6 years. The companys marginal
tax rate is40%. What is the depreciation expense
each year, and the after tax salvage in year 6, for
each of the following situations?
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Example: Straight-line Depreciation
Suppose the appropriate depreciationschedule isstraight-line
D = ($110,000 17,000) / 6 = $15,500 every year
for 6 years BV in year 6 = $110,000 6(15,500) = $17,000
After-tax salvage = $17,000 - .4(17,000 17,000)
= $17,000
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Example: Three-year MACRS
Year MACRSpercent
D
1 .3333 .3333(110,000) =
36,663
2 .4444 .4444(110,000) =48,884
3 .1482 .1482(110,000) =
16,302
4 .0741 .0741(110,000) =8,151
BV in year 6 =110,000 36,663 48,884 16,302 8,151 = 0
After-tax salvage= 17,000 -.4(17,000 0) =$10,200
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Calculating Cash Flows
Cash Flow from Capital Investments Almost every pro ect requiressome sort of initial
investment. This is often capitalized from an
accounting perspective. In finance, the investment
represents a negative cash flow.
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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: Ad usted Accounting Profits Method 3: Add Back Depreciation Tax Shield
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Blooper Industries
650,2462,2283,2113,2950,1Profit
427,1326,1230,1137,1050,1(35%).Tax078,4788,3513,3250,3000,3ProfitPretax
000,2000,2000,2000,2000,2onDepreciati
155,12576,11025,11500,10000,10Expenses
233,18364,17538,16750,15000,15Revenues
039,3679,1225214204575,2500,1in WCChange0039,3717,4493,4279,4075,4500,1WC
00010InvestCap
6543210Year
,
(,000s)
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Blooper Industries
Cash Flow From Operations (,000s)Revenues
- xpenses
Depreciation= Pro it be ore tax
.-Tax @ 35%
= Net pro it+ Depreciation
= CF rom operations
15 000
10 000
2 000
3 000
1 050
1 9502 000
3 950
,
,
,
,
,
,
,
,
or $3,950,000
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Blooper Industries
Net Cash Flow (entire pro ect) (,000s)
4,3396,3294,2384,0693,9091,37511,500-FlowCashNet
4,6514,4624,2834,1133,950OpromCF
039,31,679225-214-204-2,575-1,500-in WCChange
300,1
10,000-
valuealvage
InvestCap
6543210Year
NPV 12% = $4,222,350
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QuickQuiz
How do we determine ifcash flows arerelevant to the capital budgeting decision?
What are the common types ofcash flows?
How do we determine operatingca
sh flow
s?
What are the other 2 components of total
cash flows from a pro ect?
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