This document discusses using discounted cash flow analysis to make investment decisions. It covers topics such as identifying and calculating cash flows, using cash flows rather than accounting profits, using incremental cash flows, treating inflation, and separating investment and financing decisions. An example project for Blooper Industries is presented, showing the capital investment, revenues, expenses, taxes, depreciation, cash flows from operations, and net cash flows over several years to calculate the net present value.

1. Chapter 8
Fundamentals of
Corporate
Finance
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Using Discounted Cash Flow
Analysis to Make Investment
Decisions

2. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 2
Topics Covered
Identifying Cash Flows
Discounted Cash Flows, Not Profits
Incremental Cash Flows
Treatment of Inflation
Separate Investment & Financing Decisions
Calculating Cash Flows
Example: Blooper Industries

3. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 3
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 be
depreciated at $1,000 per year. Given a 10% required
return, compare the NPV using cash flow to the NPV
using accounting income.

4. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 4
Year 1 Year 2
Cash Income $1500 $ 500
Depreciation -$1000 -$1000
Accounting Income + 500 - 500
32
.
41
$
)
10
.
1
(
500
1.10
500
=
NPV
Apparent 2



Cash Flow vs. Accounting Income

5. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 5
Today Year 1 Year 2
Cash Income $1500 $ 500
Project Cost -2000
Free Cash Flow -2000 +1500 + 500
Cash NPV =
-2000
1.10
   
1500
110
500
110
14
2 3
( . ) ( . )
$223.
Cash Flow vs. Accounting Income

6. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 6
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
Incremental
Cash Flow
cash flow
with project
cash flow
without project
= -

7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 7
Incremental Cash Flows
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.

8. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 8
Inflation
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

9. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 9
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

10. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 10
Inflation
Example - nominal figures
$29,072.98
6,567.86
8,741.82
=
8000x1.03
3
7,014.22
20
.
487
,
8
=
8000x1.03
2
91
.
490
,
7
8,240
=
8000x1.03
1
00
.
000
,
8
8000
0
10%
@
PV
Flow
Cash
Year
3
2
10
.
1
82
.
8741
3
10
.
1
20
.
8487
2
10
.
1
8240




11. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 11
Inflation
Example - real figures
29,072.98
6,567.86
8,000
3
7,014.22
8,000
2
7,490.91
8,000
1
8,000
8,000
0
PV@6.7961%
Flow
Cash
Year
3
2
068
.
1
8,000
068
.
1
8,000
068
.
1
8,000
= $




12. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 12
Separation of Investment &
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 no, you must separate
financing and investment decisions.

13. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 13
Blooper Industries
Year 0 1 2 3 4 5 6
Cap Invest
WC
Change in WC
Revenues
Expenses
Depreciation
Pretax Profit
.Tax (35%)
Profit
10 000
1500 4 075 4 279 4 493 4 717 3 039 0
1500 2 575 204 214 225 1678 3 039
15 000 15 750 16 538 17 364 18 233
10 000 10 500 11025 11576 12 155
2 000 2 000 2 000 2 000 2 000
3 000 3 250 3513 3 788 4 078
1050 1137 1230 1326 1427
1950 2 113 2
,
, , , , , ,
, , , ,
, , , , ,
, , , , ,
, , , , ,
, , , , ,
, , , , ,
, ,
 
, , ,
283 2 462 2 651
(,000s)

14. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 14
Blooper Industries
Cash Flow From Operations (,000s)
Revenues
- Expenses
Depreciation
= Profit before tax
.-Tax @ 35 %
= Net profit
+ Depreciation
= CF from operations
15 000
10 000
2 000
3 000
1 050
1 950
2 000
3 950
,
,
,
,
,
,
,
,

or $3,950,000

15. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
McGraw-Hill/Irwin
8- 15
Blooper Industries
Net Cash Flow (entire project) (,000s)
4,339
6,329
4,237
4,069
3,909
1,375
11,500
-
Flow
Cash
Net
4,651
4,462
4,283
4,113
3,950
Op
from
CF
039
,
3
1,678
225
-
214
-
204
-
2,575
-
1,500
-
in WC
Change
300
,
1
10,000
-
value
Salvage
Invest
Cap
6
5
4
3
2
1
0
Year
NPV @ 12% = $4,222,350