FINE 3010-01 Financial Management

1. FINE 3010-01Financial Management Instructor: RogérioMazali Lecture 10: 11/02/2011

2. FINE 3010-01Instructor: RogérioMazali Fundamentals of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus McGraw Hill/Irwin Chapter 9: Using Discounted Cash-Flow Analysis to Make Investment Decisions

3. Agenda • Identifying Cash Flows • Discount Cash Flows, not Profits • Discount Incremental Cash Flows • Discount Nominal Cash Flows by the Nominal Cost of Capital • Separate Investment and Finance Decisions • Calculating Cash Flow • Capital Investment • Investment in Working Capital • Operating Cash Flow • An Example: Blooper Industries

4. Introduction • Chapter 8: used NPV to make a simple capital budgeting decision, following steps: • Step 1: Forecast Cash Flows • Step 2: Estimate OCC • Step 3: Use OCC to discount Cash-Flows. The project’s PV is equal to the sum of the discounted future cash flows • Step 4: NPV = PV – req. inv. Measures whether the project is worth more than it costs. Go ahead if NPV > 0. • In this Chapter, we will see Step 1 in further detail.

5. ID Cash Flows: Discount CFs, not Profits • Chapter 3: Cash Flows ≠ Profits • Using accounting income, rather than cash flow, could lead to erroneous decisions. • Therefore,discount Cash Flows, not profits

6. ID Cash Flows: Discount CFs, not Profits • 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.

7. ID Cash Flows: Discount CFs, not Profits

8. ID Cash Flows: Discount CFs, not Profits

9. - Incremental Cash Flow cash flow with project cash flow without project = ID Cash Flows: Discount Incremental CFs • Discount incremental cash flows • Include All Indirect Effects • Windows Vista vs. Windows XP • New airline route from Peoria, IL to Chicago O’Hare airport • Forget Sunk Costs • E.g.: Lockheed’s request for a federal guarantee for a bank loan • Include Opportunity Costs • Own the land vs. buy the land (before-after vs. with-without) • Recognize the Investment in Working Capital • WC = ST Assets – ST Liabilities • Beware of Allocated Overhead Costs • Difference in rent, heat and electricity bills • Remember Shutdown Cash Flows • E.g.: Nuclear Power Plants, Coal Mining

10. ID Cash Flows: Discount Incremental CFs IMPORTANT Ask yourself this question Would the cash flow still exist if the project does not exist? • If yes, do not include it in your analysis. • If no, include it.

11. ID Cash Flows: Separate Investment and Financing Decisions • 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 yes, consider proceeds of debt issue, interest payments and principal as part of the project; • If no, you must separate financing and investment decisions.

12. Calculating Cash Flows • Think of cash flows as coming from three elements: Total cash flow = + cash flows from capital investments + cash flows from changes in working capital + cash flows from operations

13. Calculating 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. • Example: Slick Corp. is planning to invest $800 million to develop the Mock4 razor blade. The specialized factory will run for 7 years until replaced by new technology. At this point machinery will be sold by $ 50 million. Taxes of $10 million will be assessed on the sale. $40 mil. 0 1 2 3 4 5 6 7 8 -$800 mil.

14. Calculating Cash Flows • Investment in Working Capital • Firms need to build inventories • Customers are slow to pay bills: investment is made in accounts receivable • Example: Slick Corp. makes an initial investment of $ 10 million in inventories of plastic and steel for its blade plant. Then in year 1 it accumulates an additional $20 million of raw materials. In year 5, the company begins planning the next generation of razor blades and decides to reduce its inventory of raw material from $20 million to $15 million, freeing $5 million in cash.

15. 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: Adjusted Accounting Profits • Method 3: Add Back Depreciation Tax Shield

16. Calculating Cash Flows • Example: a project generates revenues of $1,000, cash expenses of $600, and depreciation charges of $200 in a particular year. The firm’s tax bracket is 35%. Net income is calculated as follows:

17. Calculating Cash Flows • Method 1: Dollars in Minus Dollars Out • Operating CF = revenues – cash expenses – taxes = $1,000 - $600 - $70 = $330 • Method 2: Adjusted Accounting Profits • Operating CF = net profit + depreciation = $130 + $200 = $330 • Method 3: Add Back Depreciation Tax Shield • Operating CF = (rev. – cash exp.) × (1 – tax rate) + depr. × tax rate = ($1,000 - $600 ) × (1 – 0.35 ) + $200 × 0.35 = $400 × 0.65 + $200 × 0.35 = $330

18. Example: Blooper Industries • Your job: analyze a proposal for mining and selling a small deposit of high grade “magnoosium” ore for 5 years. • Forecasts: • Initial investment: $10,000 thousand • Salvage Value: $2,000 • Initial revenue: $15,000, in year 1 • Initial expenses: $ 10,000, in year 1 • Inflation rate: 5% yearly • Discount rate: 12% yearly • Customers pay with average 2 month delay • Inventories as % of expenses: 15% • Tax rate: 35% • Depreciation: 20% yearly