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Using Discounted Cash Flow Analysis to Make Investment Decisions Project Analysis

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ICFI

Using Discounted Cash Flow Analysis to Make Investment Decisions Project Analysis

By : Else Fernanda, SE.Ak., M.Sc.

- Identifying Cash Flows
- Discount Cash Flows, Not Profits
- Discount Incremental Cash Flows
- Discount Nominal Cash Flows by the Nominal Cost of Capital
- Separate Investment & Financing Decisions

- Calculating Cash Flows

Making Investment Decisions using NPV involves the following steps:

- Forecast project cash flows
- Estimate the opportunity cost of capital
- Use the opportunity cost to discount the cash flows
- NPV measures whether the investment is worth more than it costs

- 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.

- Your salesperson sells a product for $500,000 in December but gives the customer 180 days to pay.
- Accountants would treat this as an immediate change in Accounts Receivable (increasing accounts receivable now and reducing it in June when the customer pays).
- Financial Analysts would treat this as 0 cash flow today but $500,000 cash inflow in June when the customer pays.

IMPORTANT

Ask yourself this question

Would the cash flow still exist if the project does not exist?

- yes, do not include it in your analysis.
- If no, include it.

- 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

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

- 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?

- Example - nominal figures

- Example - real figures

- 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.

- 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

- 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.

- Changes in Working Capital
- Investment in Raw Material Inventories.

- 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

- Initial Investment = $10,000
- Salvage Value = $2,000
- Initial Revenue = $15,000
- Initial Expense = $10,000
- Inflation Rate = 5%
- Discount Rate = 12%
- Tax Rate = 35%

- Cash Flow from Operation ($ ,000s)
Revenues15,000

- Expenses10,000

- Depreciation 2,000

= Profit before tax 3,000

- Tax (35%) 1,050

= Net Profit 1,950

+ Depreciation 2.000

= CF from Operation 3.950

ICFI

Project Analysis

By : Else Fernanda, SE.Ak., M.Sc.

- How Firms Organize the Investment Process
- Some “What If” Questions
- Sensitivity Analysis
- Scenario Analysis
- Break Even Analysis

Capital Budget - The list of planned investment

projects.

The Decision Process

1. Develop and rank all investment projects = The Capital Budget

2. Authorize projects based on detailed proposals and backup information.

Capital Budgeting Problems

- Ensuring that forecasts are consistent
- Eliminating conflicts of interest
- Reducing forecast bias
- Selection criteria (NPV and others)

Sensitivity Analysis - Analysis of the effects on project profitability of changes in sales, costs, etc.

Scenario Analysis - Project analysis given a particular combination of assumptions.

Simulation Analysis - Estimation of the probabilities of different possible outcomes.

Break Even Analysis - Analysis of the level of sales at which the company breaks even.

Example

- Given the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital. Assume that all variables remain constant, except the one you are changing.

- Example – continued Cash Flows (years 1-12)

- Example
Given the forecasted data on the next slide, determine the level of sales required of the company in order to break even, on an NPV basis. The company’s cost of capital is 10%.

- Sales: ?
- Variable Costs: 81.25% of Sales
- Fixed Costs: $2 million
- Depreciation: $450,000
- To Break Even we need sales of: 2.45m / 0.1875
= $13.067 million

You could then divide this by the price per unit to get the

number of units you would need to sell to break even.

- Investment: $5.4 million
- Sales: ?
- Variable Costs: 81.25% of sales
- Fixed Costs: $2 million
- Depreciation: $450,000
- Calculate:
- Pretax Profit: (.1875 x Sales) - $2.45 million
- Tax (at 40%): .40 x ((.1875 x Sales) - $2.45 million)
- Profit after tax: .60 x (.1875 x Sales) - $2.45 million
- Cash Flow: 450,000 + .60 x (.1875 x Sales) - $2.45 million
= .1125 x Sales - $1.02 million

- These cash flows will occur for 12 years
- To Break Even we need sales that makes NPV = 0.
- We need to set the present value of the cash flows = investment
- Using the 12-year annuity factor (from a table or with a PV function) = 7.536 (PV of $1 a yr for each of 12 years with a discount rate of 8%):
PV of Cash Flows = 7.536 x .1125 x Sales - $1.02 million

Set this = $5.4 million (investment) …

Sales = (5.4 + 7.69)/.8478 = $15.4 million … so Sales = $15.4 million

- Operating Leverage- The degree to which costs are fixed.
- Degree of Operating Leverage (DOL) - Percentage change in profits given a 1 percent change in sales.

- Example - A company has sales outcomes that range from $16mil to $19 mil, depending on the economy. The same conditions can produce profits in the range from $550,000 to $1,112,000. What is the DOL?