CHAPTER 9: Using Discounted Cash Flow Analysis to Make Investment Decisions 9.

1 Identifying Cash Flows In order to evaluate investment projects, we have to use cash flows rather than accounting profit Using these cash flows, we have to show whether the NPV is positive or not Discount incremental cash flows: o Incremental cash flow = cash flow with project cash flow without project o Include all indirect effects: a new project might HURT sales of an existing product Launching a faster microprocessor will hurt the sales of the existing model o A new project might HELP sales of an existing product Adding a new route into an airport would increase traffic adding new revenues. o To forecast incremental cash flow you must trace out all indirect effects of accepting the project Ignore sunk costs: they are like spilled milk: they are past and irreversible outflows o The way to identify a sunk cost is to see if it remains the same whether or not you accept the project therefore they do not affect project NPV o Ex: your firm paid $100 000 last year for a marketing report for a new widget it has developed Whether or not you pursue the new widget project the cash flow for the marketing report is $100 000 THIS IS A SUNK COST Include opportunity costs: opportunity cost benefit or cash flow forgone as a result of an action. Equals the cash that could be realized from selling the land now, and therefore is a relevant cash flow for project evaluation o Ex: suppose your firm is considering building a factory on some land. Your firm purchased this land for $50 000. Its market value today is $100 000. If your firm builds the factory, there is no out of pocket cost for the land. However there is an opportunity cost. That is the value of the foregone alternative use of the land It could be sold for $100 000 Recognize the investment in working capital : net working capital current assets minus current liabilities (difference between a companys short term assets and liabilities o Most projects entail an additional investment in working capital o At the end of the project, when inventories are sold and accounts receivable are collected, the firm has a cash inflow o Investments in working capital, just like investments in plant and equipment, result in cash outflows Remember shut down cash flows: at the end of a project there is almost always additional cash flows. Ex: a nuclear plant needs to be decommissioned at costs measured in hundreds of millions. You may be able to sell some plant and equip though Beware of allocated overhead costs:

When analyzing a project, include only the incremental overhead expenses which would result from the project Discount nominal cash flows by the nominal cost of capital: nominal cash flows must be discounted at a nominal rate o Real cash flows must be discounted at a real discount rate o As long as you are consistent in your treatment of the cash flows, you will get the same results whether you use nominal or real figures. o You cannot mix and match real and nominal quantities. Real cash flows must be discounted at a real discount rate, nominal cash flows at a nominal rate. Discounting real cash flows at a nominal rate is a big mistake Separate investment and financing decisions: when calculating the cash flows from a project, ignore how the project is to be financed o This procedure focuses exclusively on the project cash flows, not the cash flows associated with alternative financing schemes. o If the project will benefit the shareholders, then conduct a separate analysis of the financing decision

9.2 Calculating Cash Flows A projects cash flow is composed of three elements o Cash flow from investments in plant and equip capital investment o Cash from investment in working capital o Cash from operations Both the initial outlay and the disposition outlay at the end of the project, minus taxes, must be included When inventories are built, or if customers are late in paying, the firm invests in working capital. These are negative cash flows Cash flow is measured by the change in working capital, not the level of working capital Operating cash flow o Operating cash flow = revenues costs taxes When working out a projects cash flows, there are three possible ways to deal with depreciation o Method 1: dollars in minus dollars out: Operating cash flow = revenues costs taxes o Method 2: adjusted accounting profits: operating cash flow = after-tax profit + depreciation o Method 3: tax shields: depreciation tax shield = depreciation x tax rate Dep. Tax shield: reduction in taxes attributable to the depreciation allowance o Cash flow from operations = (revenues cash expenses) x (1 tax rate) + (depreciation x tax rate) The term depreciation is often used by accountants in reference to the periodic charge against revenue for the cost of tangible assets. Amortization is when capital assets include intangible and tangible assets as well as natural resources and long term deferred charges

NET INCOME IS CALCULATED AS FOLLOWS: Revenues (less) cash expenses (less) depreciation expense = profit before tax (less) tax at tax rate =net income

9.3 Business Taxes in Canada In Canada, taxable income is based on a deduction called Capital Cost Allowance (CCA): o Taxable income = revenues expenses CCA o The terms depreciation and CCA are often used interchangeably but are not the same Capital Cost Allowance (CCA): the amount of write off on depreciable assets allowed by Canada Revenue Agency (CRA) against taxable income Un-depreciated Capital Cost: the balance remaining in an asset class that has not yet been depreciated in that year CCA tax shield: tax savings arising from the capital cost allowance charge o For calculating CCA, assets are assigned to different asset classes. These classes has specified CCA rates Asset class: eligible depreciable assets are grouped into specified asset classes by CRA. Each asset class has a prescribed CCA rate. Straight line depreciation: constant depreciation for each year of the assets accounting life Declining balance depreciation: this is computed by applying the depreciation rate to the asset balance for each year Half year rule: only one half of the purchase cost of the asset is added to the asset class and used to compute CCA in the year of purchase SALE OF ASSETs When a depreciable asset is sold, the un-depreciated capital cost of its asset class is reduced by either the assets sale price or its initial cost, whichever is less. This is called the adjusted cost of disposal Net acquisitions rule: we determine the total cost of all additions to an asset class and then subtract the adjusted cost of disposal of all assets in that class TERMINATION OF ASSET POOL Terminal loss: the positive balance following the disposal of all assets in the class. The UCC of the asset class is set to zero after a terminal loss is recognized Recaptured depreciation: the negative balance that is caused in an asset class by the sale of an asset. Recaptured depreciation is added to taxable income Intangible assets use a straight line depreciation method for computing CCA Most asset classes use a declining balance method for computing CCA

o The tax shield generated by CCA generally has an infinite life o Projects typically have a finite life When computing NPV, we calculate the present value of the operating cash flow separately from the present value of the CCA tax shields

PRESENT VALUES OF CCA TAX SHIELDS

Summary of Chapter 9 Discount cash flows not profits Estimate incremental cash flow Forget sunk costs Dont forget opportunity costs Remember investment in working capital Treat inflation consistently Beware of allocated overhead charges Separate the investment and financing decision In Canada, a companys tax bill is determined by its CCA, not its book depreciation o Use CCA when calculating the projects cash flows o CCA tax shields have an infinite life o Projects have a fixed life