musings of a budding social entrepeneur

Monday, October 19, 2009

Chapter 9 - Usind Discounted Cash-Flow Analysis to Make Investment Decisions

Learning Objectives
  1. Identify the cash flows properly attributable toa proposed new project
  2. Calculate the cash flows of a porject from standard financial statements
  3. Understand how the company's tax bill is affected by depreciation and how this affects project value
  4. Understand how changes ni working capitral affect project cash flows.
Review:  Estimating NPV
  1. Forecase the project cash flows
  2. Estimate the opportunity cost of capital, that is, the rate of return that you shareholders could expect to earn if they invested their money in the capital market.
  3. Use the opportunity cost of capital to discount the future cash flows. The projects's present value (PV) is equal tot he sum of the discounted future cash flows.
  4. NPV measures whether the project is worth more than it costs. To calculate NPV,  you need to subtract the required investment from the present value of the future payoffs:
NPV = PV - required investement

When you discount NPV, discount CASH FLOWS, not accounting profits.
Recognize expenses when they occur, not when they show up as depreciation. 

Incremental Cash Flows
A projects present value depends on teh extra cash flows that it produces. So you need to forecast first the firms cash flows if you go ahead with thte project, then forecas the cash flows if you don't accept the project. Take the diff and you have the increamental cash flows

Incremental cash flow = cash flow with project - cash flow without project.
Example: Windows Vista

Inclue all indirect effects when forecasting cash flows.
Sometimes a new project will help the firms existing business indirectly. don't just look at the NPV in isolation.
example: adding new flight to airline service.

Dont include sunk costs. Example, lockheeds Tristar airplane. They sunk nearly $1 billion on the project and were tryign to decide on whether to .. But how do you know when somethign is fully sunk?

Include opportunity costs
Def opportunity cost - benefit of cash flow forgone as a result of an action .
Recognize the investment in working capital 
Def net working capital - current assets minus current liabilities.

Remember shut down cash flows
example: nuclear power plants, coal mines are very expensive. However, certain shutdown costs can be cash inflows, from selling of equipment, plants, inventories.

Ignore financing decisions when forecasting cash flows for NPV. Regardless of whether you finance with debt or with equity. Keep the invesmtnet decision seperate from the financing decision. first ask whether the project has positive NPV, then if it does, figure out the best financing strategy.

9.2 Calculating Cash flow
Total cash flow = Cash flows from capital invesmtents
+ cash flows from chagnes in working capital
+ operating cash flows.

Capital investments
In general, an increase in working capital is an investment adn therefore implies a negative cash flow. a decrease in working cap implies a positive cash flow. The cash flow is measured byt the change in working capital, not the lievel of working capital.

Operating Cash Flow = revenues - costs - taxes.

Dealing with depreciation when working out project's cash flows (pg 267) See three methods for operating cash flow.

Depreciation example - straight line depreciation: constat depreciateion each eyar of the asset's accounting life. for JBEI question. 
Deprecitation Tax Shield - pg 271
Straight line depreciation is one method, but Modified accelerated cost recovery system (MACRS) is another
Depreciation method that allows higher tax deductions in early years and lower deductions later

All large corporations use two sets of books, one for stockholders with straight line depreciation and one for the IRS with MACRS.  Only the tax books are relevant in capital budgeting.
9.3 - Great Example (pg  269)


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