Chapter Using Discounted Cash-Flow Analysis to Make Investment Decisions We look first at what cash flows should be discounted.

t cash flows should be discounted. differ. The example will lead us to various further points,
We then present an example that shows how cash flows including the links between depreciation and taxes and
can be derived from standard accounting information the importance of tracking investments in working
Projects are financially attractive because of the cash they generate, either for and why cash flows and accounting income usually capital.
distribution to shareholders or for reinvestment in the firm. Therefore, the focus
of capital budgeting must be on cash flow, not profits.

. Self-Test 9.1 Identifying Cash Flows

A regional supermarket chain is deciding whether to install a tewgit machine in Discount Cash Flows, Not Profits
each of its stores. Each machine costs $ , . Projected income per machine Up to this point we have been concerned mainly with the mechanics of discounting and
is as follows: with the various methods of project appraisal. We have had almost nothing to say about
the problem of what you should discount. The first and most important point is this: To
Year: calculate net present value, you need to discount cash flows, not accounting profits.
Sales $ , $ , $ , $ , $ , We stressed the difference between cash flows and profits in Chapter 3. Here we
Operating expenses , , , , , stress it again. Income statements are intended to show how well the firm has per-
Depreciation , , , , , formed. They are not designed to track cash flows.
Accounting income , , If the firm lays out a large amount of money on a big capital project, you do not
conclude that the firm performed poorly that year, even though a lot of cash is going
Why would a store continue to operate a machine in years and if it produces out the door. Therefore, the accountant does not deduct capital expenditure when cal-
no profits? What are the cash flows from investing in a machine? Assume each culating the year’s income but, instead, depreciates it over several years.
tewgit machine has no salvage value at the end of its five-year life. Ignore taxes. That is appropriate for computing year-by-year profits, but it could get you into
trouble when working out net present value. For example, suppose that you are analyz-
ing an investment proposal. It costs $2,000 and is expected to bring in a cash flow of
We saw another example of the distinction between cash flow and accounting prof- $1,500 in the first year and $500 in the second. You think that the opportunity cost of
its in Chapter 3. Accountants try to show profit as it is earned, rather than when the capital is 10% and so calculate the present value of the cash flows as follows:
company and the customer get around to paying their bills. For example, an income $1,500 $500
statement will recognize revenue when the sale is made, even if the bill is not paid for PV = _____ + _____2 = $1,776.86
1.10 (1.10 )
months. This practice also results in a difference between accounting profits and cash
flow. The sale generates immediate profits, but the cash flow comes later. The project is worth less than it costs; it has a negative NPV:
NPV = $1,776.86 − $2,000 = −$223.14
Example . ⊲ When Cash Flow Comes Later Than Sales The project costs $2,000 today, but accountants would not treat that outlay as an
immediate expense. They would depreciate that $2,000 over two years and deduct the
Your firm’s ace computer salesman closed a $ , sale on December , just in time to depreciation from the cash flow to obtain accounting income:1
count it toward his annual bonus. How did he do it? Well, for one thing he gave the customer
days to pay. The income statement will recognize the sale in December, even though Year Year
cash will not arrive until June. Cash inflow +$ , +$
To take care of this timing difference, the accountant adds $ , to accounts receiv- Less depreciation − , − ,
able in December and then reduces accounts receivable when the money arrives in June. Accounting income + −
(The total of accounts receivable is just the sum of all cash due from customers.)
You can think of the increase in accounts receivable as an investment—it’s effectively a Thus, an accountant would forecast income of $500 in year 1 and an accounting loss of
-day loan to the customer—and, therefore, a cash outflow. That investment is recovered $500 in year 2.
when the customer pays. Thus, financial analysts often find it convenient to calculate cash Suppose you were given this forecast income and loss and naively discounted them.
flow as follows: Now NPV looks positive:
$500 − $500
Apparent NPV = ____ + _____2 = $41.32
December June 1.10 (1.10 )
Sales $ , Sales
Of course we know that this is nonsense. The project is obviously a loser; we are
Less investment in Plus recovery of
accounts receivable
spending money today ($2,000 cash outflow), and we are simply getting our money
− , accounts receivable +$ ,
back later ($1,500 in year 1 and $500 in year 2). We are earning a zero return when we
Cash flow Cash flow $ ,
could get a 10% return by investing our money in the capital market.
Note that this procedure gives the correct cash flow of $ , in June. ■ The message of the example is this: When calculating NPV, recognize invest-
ment expenditures when they occur, not later when they show up as depreciation.
It is not always easy to translate accounting data back into actual dollars. If you are 1
For reporting purposes, firms typically spread depreciation evenly over the life of the project, as we assume
in doubt about what is a cash flow, simply count the dollars coming in and take away here. This figure may differ from the depreciation allowed for tax purposes. We discuss this issue in more detail
the dollars going out. later in the chapter.
 Chapter Using Discounted Cash-Flow Analysis to Make Investment Decisions Part Two Value

cancel the program, supporters of the project argued that it would be foolish to abandon Discount Incremental Cash Flows
a project on which so much had already been spent. Others countered that it would be
A project’s present value depends on the extra cash flows that it produces. So you need
even more foolish to continue with a project that had proved so costly. Both groups were
to forecast first the firm’s cash flows if you go ahead with the project. Then forecast
guilty of the sunk-cost fallacy; the money that had already been spent by NASA was
the cash flows if you don’t accept the project. Take the difference and you have the
irrecoverable and, therefore, irrelevant to the decision to terminate the project.
extra (or incremental) cash flows produced by the project:
Include Opportunity Costs Resources are almost never free, even when no cash Incremental cash flow = cash flow with project − cash flow without project
changes hands. For example, suppose a new manufacturing operation uses land that
could otherwise be sold for $100,000. This resource is costly; by using the land, you
pass up the opportunity to sell it. There is no out-of-pocket cost, but there is an Example . ⊲ Launching a New Product
opportunity cost opportunity cost—that is, the value of the forgone alternative use of the land. Consider the decision by Apple to develop a successor to the iPhone . If successful, an
Benefit or cash flow This example prompts us to warn you against judging projects “before versus after”
iPhone could lead to several billion dollars in profits.
forgone as a result of an rather than “with versus without.” A manager comparing before versus after might not
action. But would these profits all be incremental cash flows? Certainly not. Our with-versus-without
assign any value to the land because the firm owns it both before and after:
principle reminds us that we need also to think about what the cash flows would be without the
new phone. By launching the iPhone , Apple will reduce demand for the iPhone . The
Cash Flow,
Before Take Project After Before versus After incremental cash flows therefore are
Firm owns land Firm still owns land Cash flow with cash flow without
[(including lower cash flow − (with higher cash flow
[
The proper comparison, with versus without, is as follows: from iPhone ) from iPhone )
[ [
■
Cash Flow,
Before Take Project After with Project The trick in capital budgeting is to trace all the incremental flows from a proposed
Firm owns land Firm still owns land project. Here are some things to look out for.

Do Not Take Cash Flow, Include All Indirect Effects The decision to launch a new smartphone illustrates a
Before Project After without Project common indirect effect. New products often damage sales of an existing product. Of
Firm owns land Firm sells land for $ , $ , course, companies frequently introduce new products anyway, usually because they
believe that their existing product line is under threat from competition. Even if Apple
If you compare the cash flows with and without the project, you see that $100,000 is doesn’t go ahead with a new product, Samsung, Huawei, and other competitors will
given up by undertaking the project. The original cost of purchasing the land is surely continue to improve their Android phones, so there is no guarantee that sales of the
irrelevant—that cost is sunk. The opportunity cost equals the cash that could be existing product line will continue at their present level. Sooner or later they will decline.
realized from selling the land now; you lose that cash if you take the project. Sometimes, a new project will help the firm’s existing business. Suppose that you
When the resource can be freely traded, its opportunity cost is simply the market are the financial manager of an airline that is considering opening a new short-haul
price.2 However, sometimes opportunity costs are difficult to estimate. Suppose that route from Peoria, Illinois, to Chicago’s O’Hare Airport. When considered in isola-
you go ahead with a project to develop Computer Nouveau, pulling your software tion, the new route may have a negative NPV. But once you allow for the additional
team off their work on a new operating system that some existing customers are not- business that the new route brings to your other traffic out of O’Hare, it may be a
so-patiently awaiting. The exact cost of infuriating those customers may be impossible worthwhile investment. To forecast incremental cash flow, you must trace out all
to calculate, but you’ll think twice about the opportunity cost of moving the software indirect effects of accepting the project.
team to Computer Nouveau. Some capital investments have very long lives once all indirect effects are recog-
nized. Consider the introduction of a new jet engine. Engine manufacturers often offer
net working capital Recognize the Investment in Working Capital Net working capital (often attractive pricing to achieve early sales because, once an engine is installed, 15 years’
Current assets minus referred to simply as working capital) is the difference between a company’s short- sales of replacement parts are almost ensured. Also, because airlines prefer to limit the
current liabilities. Often term assets and its liabilities. The principal short-term assets that you need to consider number of different engines in their fleet, selling jet engines today improves sales
called working capital. are accounts receivable (customers’ unpaid bills) and inventories of raw materials and tomorrow as well. Later sales will generate further demands for replacement parts.
finished goods, and the principal short-term liabilities are accounts payable (bills that Thus, the string of incremental effects from the first sales of a new-model engine can
you have not paid) and accruals (liabilities for items such as wages or taxes that have run for 20 years or more.
recently been incurred but have not yet been paid).
Most projects entail an additional investment in working capital. For example, before Forget Sunk Costs Sunk costs are like spilled milk: They are past and irreversible
you can start production, you need to invest in inventories of raw materials. Then, when outflows. Sunk costs remain the same whether or not you accept the project.
you deliver the finished product, customers may be slow to pay and accounts receivable Therefore, they do not affect project NPV.
Take the case of the James Webb Space Telescope. It was originally supposed to
2 launch between 2007 and 2011 and cost $1.6 billion. But the project became progres-
If the value of the land to the firm were less than the market price, the firm would sell it. On the other hand,
the opportunity cost of using land in a particular project cannot exceed the cost of buying an equivalent parcel to sively more expensive and further behind schedule. Latest estimates put the cost at nearly
replace it. $10 billion and the launch date sometime in 2021. When Congress debated whether to
 Chapter Using Discounted Cash-Flow Analysis to Make Investment Decisions Part Two Value

will increase. (Remember the computer sale described in Example 9.1. It required a
a. The market value of the site. $500,000, six-month investment in accounts receivable.) Next year, as business builds
b. The market value of the existing buildings. up, you may need a larger stock of raw materials and you may have even more unpaid
c. Demolition costs and site clearance. bills. Investments in working capital, just like investments in plant and equipment,
d. The cost of a new access road put in last year. result in cash outflows.
e. Lost cash flows on other projects due to executive time spent on the new Working capital is one of the most common sources of confusion in forecasting
facility. project cash flows.3 Here are the most common mistakes:
f. Future depreciation of the new plant.
g. The reduction in the firm’s tax bill resulting from depreciation of the new plant. 1. Forgetting about working capital entirely. We hope that you never fall into that trap.
h. The initial investment in inventories of raw materials. 2. Forgetting that working capital may change during the life of the project. Imagine
i. Money already spent on engineering design of the new plant. that you sell $100,000 of goods per year and customers pay on average six months
late. You will, therefore, have $50,000 of unpaid bills. Now you increase prices by
10%, so revenues increase to $110,000. If customers continue to pay six months
late, unpaid bills increase to $55,000, and therefore, you need to make an additional
Discount Nominal Cash Flows investment in working capital of $5,000.
by the Nominal Cost of Capital 3. Forgetting that working capital is recovered at the end of the project. When the
Interest rates are usually quoted in nominal terms. If you invest $100 in a bank deposit project comes to an end, inventories are run down, any unpaid bills are (you hope)
offering 6% interest, then the bank promises to pay you $106 at the end of the year. It paid off, and you can recover your investment in working capital. This generates a
makes no promises about what that $106 will buy. The real rate of interest on the bank cash inflow.
deposit depends on inflation. If inflation is 2%, that $106 will buy you only 4% more
goods at the end of the year than your $100 could buy today. The nominal rate of inter- Remember Terminal Cash Flows The end of a project almost always brings addi-
est is 6%, but the real rate is about 4%. 4 tional cash flows. For example, you might be able to sell some of the plant, equipment,
If the discount rate is nominal, consistency requires that cash flows be estimated in or real estate that was dedicated to it. Also, as we just mentioned, you may recover
nominal terms as well, taking account of trends in selling price, labor and materials some of your investment in working capital as you sell off inventories of finished
costs, and so on. This calls for more than simply applying a single assumed inflation goods and collect on outstanding accounts receivable.
rate to all components of cash flow. Some costs or prices increase faster than inflation, Sometimes, there may be costs to shutting down a project. For example, the decom-
some slower. For example, perhaps you have entered into a five-year fixed-price con- missioning costs of nuclear power plants can soak up several hundred million dollars.
tract with a supplier. No matter what happens to inflation over this period, this part of Similarly, when a mine is exhausted, the surrounding environment may need rehabili-
your costs is fixed in nominal terms. tation. The mining company FCX has earmarked $454 million to cover the future
Of course, there is nothing wrong with discounting real cash flows at the real inter- closure and reclamation costs of its New Mexico mines. Don’t forget to include these
est rate, although this is not commonly done. We saw in Chapter 5 that real cash flows terminal cash flows.
discounted at the real discount rate give exactly the same present values as nominal
cash flows discounted at the nominal rate. Beware of Allocated Overhead Costs We have already mentioned that the
While the need to maintain consistency may seem like an obvious point, analysts accountant’s objective in gathering data is not always the same as the project analyst’s.
sometimes forget to account for the effects of inflation when forecasting future cash A case in point is the allocation of overhead costs such as rent, heat, or electricity.
flows. As a result, they end up discounting real cash flows at a nominal discount rate. These overhead costs may not be related to a particular project, but they must be paid
This can grossly understate project values. for nevertheless. Therefore, when the accountant assigns costs to the firm’s projects, a
It should go without saying that you cannot mix and match real and nominal charge for overhead is usually made. But our principle of incremental cash flows says
quantities. Real cash flows must be discounted at a real discount rate, nominal that in investment appraisal we should include only the extra expenses of the project.
cash flows at a nominal rate. Discounting real cash flows at a nominal rate is a A project may generate extra overhead costs, but then again it may not. We
big mistake. should be cautious about assuming that the accountant’s allocation of overhead
costs represents the incremental cash flow that would be incurred by accepting
the project.
Example . ⊲ Cash Flows and Inflation
City Consulting Services is considering moving into a new office building. The cost of a
one-year lease is $ , , paid immediately. This cost will increase in future years at the . Self-Test
annual inflation rate of %. The firm believes that it will remain in the building for four years.
What is the present value of its rental costs if the discount rate is %?
A firm is considering an investment in a new manufacturing plant. The site
4
already is owned by the company, but existing buildings would need to be
Remember from Chapter 5,
demolished. Which of the following should be treated as incremental cash flows?
Real rate of interest ≈ nominal rate of interest − inflation rate
The exact formula is

1 + real rate of interest = _______________________

1 + nominal rate of interest = ____
1.06 = 1.0392
1 + inflation rate 1.02 3
If you are not clear why working capital affects cash flow, look back to Chapter 3, where we gave a primer on
Therefore, the real interest rate is .0392, or 3.92%. working capital and a couple of simple examples.
Part Two Value

The present value can be obtained by discounting the nominal cash flows at the %
discount rate as follows:

Present Value at
Year Cash Flow % Discount Rate
, ,
, × . = , , / . = ,
, × . = , , /( . ) = ,
, × . = , , /( . ) = ,
$ ,

Alternatively, the real discount rate can be calculated as . / . − = . = . %.

The present value can then be computed by discounting the real cash flows at the real dis-
count rate as follows:

Present Value at
Year Real Cash Flow . % Discount Rate
, ,
, , / . = ,
, , /( . ) = ,
, , /( . ) = ,
$ ,

Notice the real cash flow is a constant because the lease payment increases at the rate of
inflation. The present value of each cash flow is the same regardless of the method used to
discount it. The sum of the present values is, of course, also identical. ■

. Self-Test
Nasty Industries is closing down an outmoded factory and throwing all of its work-
ers out on the street. Nasty’s CEO is enraged to learn that the firm must continue to
pay for workers’ health insurance for four years. The cost per worker next year will
be $ , per year, but the inflation rate is %, and health costs have been increas-
ing at three percentage points faster than inflation. What is the present value of this
obligation? The (nominal) discount rate is %. The company does not pay taxes.

Separate Investment and Financing Decisions

Suppose you finance a project partly with debt. How should you treat the proceeds
from the debt issue and the interest and principal payments on the debt? The answer:
You should neither subtract the debt proceeds from the required investment nor recog-
nize the interest and principal payments on the debt as cash outflows. Regardless of
the actual financing, you should start by viewing the project as if it were all-equity-
financed, treating all cash outflows required for the project as coming from stockhold-
ers and all cash inflows as going to them.6
This procedure focuses exclusively on the project cash flows, not the cash flows
associated with alternative financing schemes. Financing decisions are considered
later in the text.

5
We calculate the real discount rate to three decimal places to avoid confusion from rounding. Such precision
is rarely necessary in practice.
6
Notice that this means that when you calculate the working capital associated with the project, you should
assume zero short-term debt or holdings of cash.