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Chapter 9

Using Discounted
Cash Flow
Analysis to Make
Investment
Decisions

Prepared by
Humayun Qadri © 2020 McGraw-Hill Education Limited
MacEwan University
Learning Objectives
After studying this chapter, you should be
able to:
 LO1 Identify the cash flows properly

attributable to a proposed new project.


 LO2 Calculate the cash flows of a project

from standard financial statements.


 LO3 Explain how the company’s tax bill is

affected by depreciation and how this


affects project value.
 LO4 Explain how changes in working

capital affect project cash flows.


© 2020 McGraw-Hill Education Limited
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9.1 Identifying Cash Flows
 In previous chapter we used the NPV rule to make simple
capital budgeting decisions.
 We now apply the NPV rule to practical investment problems.
 The first step is to decide what cash flows should be
discounted.
 We must use cash flows and not accounting profit.

Example:
 A project costs $2,000 today and has an opportunity cost of

capital of 10%. It has a 2 year life and will produce cash


flows of $1,500 in year 1 and $500 in year 2. The asset will
be depreciated over 2 years.
 Compare the NPV using cash flows, to the NPV using

accounting income.

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Discount Cash Flows, Not Profits

t=1 t=2
Cash Inflow +$1,500 +$500
Less: Depreciation -1,000 -1,000
Accounting Income +500 -500

We would calculate NPV using cash flows as follows:


1,500 500
𝑁𝑃𝑉 =− 2,000 + +
1.1 0 1 ¿ ¿

Reject, as NPV is negative

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Discount Cash Flows, Not Profits
 Accountants would not treat the outlay as an immediate expense
but would depreciate over 2 years. Using accounting income, we
would get:

500  500
Accounting income NPV   2
41.32
1.10 (1.10)

 This is clearly incorrect. When calculating NPV, recognize


investment expenditures when they occur not when they show
up as depreciation.
 Projects are attractive because of the cash flow they generate so
the focus must be on cash flows, not profits

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Incremental Cash Flows Cash
Flows
A project’s PV depends on the extra (or
incremental) cash flow it produces:
Incremental cash flow = cash flow with
project – cash flow without project.

 Would this cash flow still exist if the project did


not exist? If the answer is:

No? Yes?
Include the cash flow in the Do not include the cash flow
analysis. in the analysis.

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Identifying Cash Flows
 Here are some things to look out for:
 Include all indirect effects.
 Forget sunk costs.
 Include opportunity costs.
 Recognize the working capital investment.
 Remember shutdown cash flows.
 Beware of allocated overhead costs.
 Discount nominal cash flows by the nominal
cost of capital.
 Separate investment and financing decisions.

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Identifying Cash Flows
 Include all Indirect Effects
 Example:
 A new product might hurt sales of an existing
product
 Launching a faster microprocessor will hurt
the sales of the existing model.

 A new project might help the firm’s existing


business.
 Adding a new route into an airport would
increase traffic, adding new revenues.

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Identifying Cash Flows
 Ignore Sunk Costs
 Sunk costs are like spilled milk: they are past
and irreversible outflows!
 The way to identify a sunk cost is to see if it
remains the same whether or not you accept
the project.

 Example:
 Your firm paid $100,000 last year for a
marketing report for a new widget it has
developed.
 Whether or not you pursue the new widget
project, the cash flow for the marketing report is
$100,000. © 2020 McGraw-Hill Education Limited
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Identifying Cash Flows
 IncludeOpportunity Costs: It is the benefit or
cash flow forgone as a result of an action
 Suppose your firm is considering building a
factory on land owned by the firm. The market
value of the land today is $100,000. If your firm
builds the factory, there is no out-of-pocket cost
for the land.
 However, there is an opportunity cost:
 The opportunity cost equals the cash that could
be realized from selling the land now
($100,000).
 It is a relevant cash flow for project evaluation.
© 2020 McGraw-Hill Education Limited
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Identifying Cash Flows
 Recognize the investment in working
capital:
 Net working capital is the difference between a
firm’s short-term assets and liabilities
 Most projects require an additional investment
in working capital (cash outflow).
 For example additional inventory required to
keep up with production, or higher accounts
receivable due to increased sales.
 At the end of the project, when inventories are
sold and accounts receivable are collected, the
firm has a cash inflow.
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Identifying Cash Flows
 Remember Shutdown Cash Flows:
Examples:
 Outflows - costs associated with closing down
coal mine and rehabilitation of their surrounding
environments.
 Inflows – salvage value on sale of plant,
equipment or real estate.

 Beware of Allocated Overhead Costs:


 When analyzing a project, include only the
incremental overhead expenses which would
result from the project.

© 2020 McGraw-Hill Education Limited


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Identifying Cash Flows
 Discount nominal cash flows by the nominal
cost of capital:
 Interest rates are usually quoted in nominal
terms. Nominal cash flows must be discounted
at a nominal rate.
 Real cash flows must be discounted at a real
discount rate.
 As long as you are consistent in your treatment
of the cash flows, you will get the same results
whether you use nominal or real figures.
 Discounting real cash flows at a nominal rate is
a big mistake. © 2020 McGraw-Hill Education Limited
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Cash Flows and Inflation

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Example 9.3 – Cash Flows and Inflation

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Identifying Cash Flows
 Separate Investment and Financing
Decisions

 When calculating the cash flows from a project,


ignore how the project is to be financed.

 Do not subtract the debt proceeds from the


required investment nor recognize the interest
and principal payments as cash outflows.

 If the project will benefit the shareholders


(positive NPV), then conduct a separate analysis
of the financing decision.
© 2020 McGraw-Hill Education Limited
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9.2 Calculating Cash Flows
A project’s cash flow is composed of three
elements:

1. Cash flow from investments in plant and


equipment – capital investment.

2. Cash flow from investment in working


capital

3. Cash flow from operations

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Calculating Cash Flows
Capital Investment:
 Both the initial outlay (cash outflow) and
the salvage value at the end of the project
(cash inflow) have to be included.

Investment in Working Capital


 An increase in working capital is an
investment, and therefore implies a
negative cash flow; a decrease implies a
positive cash flow. The cash flow is
measured by the change in working
capital, not the level of working capital.
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Calculating Cash Flows

Operating Cash Flow

 Many investments do not result in additional


revenues but may reduce costs. These cost
savings represent positive operating cash
flows.

 Depreciationis a non-cash expense and


should not be deducted when calculating
operating cash flow.

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Example 9.6 - Calculating Cash
Flows
Three ways to deal with depreciation:
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:
Revenues $1,000
− Cash expenses 600
− Depreciation expense 200
= Profit before tax 200
− Tax at 35% 70
= Net income $130

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Example 9.6 Calculating Cash
Flows
Method 1: CF from operations = revenues –
cash expenses– taxes
= 1000 – 600 – 70 = 330

Method 2: CF from operations = net profit +


depreciation
= 130 + 200 = 330

Method 3: CF from operations


= (revenues – expenses)*(1 – Tax rate) +
(Depreciation*Tax rate)
= (1000 – 600)*(0.65) +
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9.3 Business Taxes in Canada and
the Capital Budgeting Decision
 When calculating taxable income, a company
may deduct an amount for depreciation on its
depreciable assets - called Capital Cost
Allowance (CCA):
 Capital Cost Allowance (CCA): The amount of
write-off on depreciable assets allowed by the
Canada Revenue Agency (CRA) against taxable
income.
 Taxable Income = Revenues - Expenses - CCA

 Undepreciated Capital Cost (UCC): The balance


remaining in an asset class that has not yet been
depreciated in that year.
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Business Taxes in Canada
 The tax savings arising from CCA is called
the CCA tax shield.
 The terms depreciation (accounting purposes)
and CCA (tax purposes) are often used
interchangeably but they are not necessarily the
same.
 For calculating CCA, depreciable assets are
grouped into one of over 30 CCA asset classes.
Each asset class has been assigned a CCA rate
by CRA.
 Under the asset class system, all assets within a
particular CCA class are depreciated for tax
purposes as if they were a single asset.
© 2020 McGraw-Hill Education Limited
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Business Taxes in Canada
 Intangible assets such as leasehold
improvements or patents follow the
straight-line depreciation method for
computing CCA.
 Most
asset classes use a declining balance
method for computing CCA.
 The tax shield generated by CCA generally has
an infinite life.
 Projects typically have a finite life.
 When computing NPV, we calculate the
present value of the operating cash flow
separately from the present value of the
CCA tax shields.
© 2020 McGraw-Hill Education Limited
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Business Taxes in Canada
 Half-yearrule: Only one-half of the
purchase cost of the asset is added to the
asset class and used to compute CCA in the
year of purchase

 When an asset is sold, the UCC of the asset


class is reduced by the lesser of the asset’s
sale price or its initial cost, whichever is
less.

 When as asset class closes (last asset in


that class is sold), there will be a terminal
loss (positive balance remaining) or
© 2020 McGraw-Hill Education Limited
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Business Taxes in Canada
 Acceleratedinvestment incentive: The
Government of Canada’s 2018 Fall
Economic Statement, has proposed an
Accelerated Investment Incentive measure.

 Certain capital assets that are subject to


CCA rules (referred to as “eligible property”)
will be eligible for an enhanced first-year
allowance.

 Assetscurrently subject to this rule will, in


essence, qualify for an enhanced CCA equal
to three times the normal first-year
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Business Taxes in Canada
The PV of the CCA Tax Shield is equal to:
 CdTc   1  0.5r   SdTc   1 
 r  d   1 r    r  d    t 
      1 r 

where:
C= capital cost of asset acquired today
d= CCA rate for the asset class to which the asset belongs
TC = firm’s tax rate
r = discount rate
S = salvage value from sale of asset at the end of Year t

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9.4 Example – Blooper Industries
Table 9.6
Year 0 1 2 3 4 5 6
Capital 10,000
Investment
Working Capital 1,500 4,075 4,279 4,493 4,717 3,039 0
(WC)
Change in WC 1,500 2,575 204 214 224 -1,678 -3,039

Revenues 15,000 15,750 16,538 17,364 18,233

Expenses 10,000 10,500 11,025 11,576 12,155

CCA of Mining 1,500 2,550 1,785 1,250 875 612


Equip 30%
Pre-tax profit 3,500 2,700 3,278 4,538 5,203

Tax 1,225 945 1,305 1,588 1,821

Profit after tax 2,275 1,755 2,423 2,950 3,382

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Example – Blooper Industries Table 9.8

 Operating Cash Flows excluding CCA tax shield:

Year 0 1 2 3 4 5
Revenues 15,000 15,750 16,538 17,364 18,233

- Expenses 10,000 10,500 11,025 11,576 12,155

= Profit before tax 5,000 5,250 5,513 5,788 6,078

- Tax at 35% 1,750 1,838 1,930 2,026 2,127

= Operating CF 3,250 3,412 3,583 3,762 3,951


(excluding CCA tax
shield)

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Example – Blooper Industries Table 9.9

 Total Cash Flows excluding CCA tax shield:


Year 0 1 2 3 4 5 6
Capital Investment -10,000

Change in WC -1,500 -2,575 -204 -214 -224 1,678 3,039

CF from operations 3,250 3,412 3,583 3,762 3,951


(excluding CCA tax shield)
Total CF (excluding CCA tax -11,500 675 3,208 3,369 3,538 5,629 3,039
shield)

Using a discount rate of 12%, the PV of these cash flows is $1,040

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Example – Blooper Industries
 Present Value of the CCA tax shield:

 CdTC   1  0.5r   SdTC   1 


 r  d   1 r    r  d   1  r t 
     
 10,000 0.3 0.35   1  0.5 0.12   0 0.3 0.35   1 
      0.12  0.3   1  0.12 6 
 0.12  0.3   1  0.12   
2,366

© 2020 McGraw-Hill Education Limited


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Example – Blooper Industries
Net present value (NPV) =
Total PV excluding CCA tax shield + PV of CCA tax shield
= $1,040 + $2,366
= $3,406

© 2020 McGraw-Hill Education Limited


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Summary
 When estimating a project’s cash flows:

Discount cash flows not accounting profits.

Estimate incremental cash flows.

Include all indirect effects of the project.

Forget sunk costs.

Include opportunity costs.

Beware of allocated overhead charges.

Remember investment in working capital.

Remember shutdown cash flows.

Do not include debt interest or the cost of
repaying a loan.

Separate the investment and financing
decisions.
© 2020 McGraw-Hill Education Limited
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Summary
 Projectcash flows do not equal profit. Allow
for changes in working capital and
depreciation.
 CCA (a non-cash expense). CCA reduces

taxable income and tax (CCA tax shield).


 Most asset classes use declining balance to
calculate CCA.
 Most assets generate CCA tax shields over an
infinite time frame.
 Calculate PV of operating cash flows separately
from the PV of the CCA tax shields.
 Increases in net WC are a use of cash –
© 2020 McGraw-Hill Education Limited
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