Chapter 9 Using Discounted Cash

Flow Analysis to Make Investment

Decisions
TOPICS COVERED
• 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
 • COI= Cost of
Capital investment
Budgeting • NPV= Net Present
Value
• PVCI= PV of Cash
Inflows
• PVCO= PV of
DCF Cash Outflows
Analysis • IRR= Internal
Rate of Return

Discounted
NPV Propfitability Payback
IRR Index Period

PVCI-PVCO NPV = 0 NPV/COI COI/PVCI

 IRR
(NPV=0)

IRR>Discount Rate= Accept

IRR<Discount Rate=reject
The Higher IRR the Better!
Why?

If the IRR is higher, PVF is

lower, the PV of Cash inflows
is also lower. Since at IRR,
the PV of Cash inflows equals
the COI, then the cost of
investment also goes lower.
The lower COI is favorable in
the part of the business.
Interpolation Process - Even
Cash flows
Given:
COI= P1million
Useful life= 4 yrs.
Net cash inflow= P375K
Rate of Return= 14%
Solutions/Discussions:
PVFA=P 1million/ P375K = 2.667
PVFA @ 14%= 2.914
*make the IRR Higher!
The IRR is between 18% and 20%
PVFA @ 18%=2.690
PVFA @ 20%=2.589

Determine the IRR or the

adjusted rate of return? Discount Rate
18% 2.690
0.023
2% 2.667 0.101
0.078
20% 2.589

IRR= 18% + (2% * 0.023/.101)= 18.46%

IRR= 20% - (2% * 0.078/.101)= 18.46%

How about for UNEVEN CASH FLOWS?

*Please read Management Services 2014 edition by Agamata @ page 742

NPV= PVCI: Incremental revenues
Reduction in Cost/ Cost
savings
Salvage Value@ PV
Release of Working Capital/
Disinvestment @PV
Less:
PVCO: COI/ Initial investment
Increase in Working Capital
Repairs and Maintenance
Incremental Operating Cost
• When calculating NPV, recognize
investment when they occur, not later
when they show up as depreciation.
Projects are financially attractive because
of the cash they generate, either for
distribution to the shareholders or for
reinvestment in the firm. Therefore. The
focus of capital budgeting must be on
cash outflows, not profits.
Ex. The effect on inflows as a result of the
change in demand
Include opportunity Costs- Forgone benefits or cash flow as a
result of an action

Example:
The forgone benefit from selling the land if the project is accepted.

Before Decision After Cash Flow

Firm owns land Take project Firm still owns 0
the land
Firm owns land Do not take the Firm sell land for 100K
project 100K

The opportunity cost is the cash that could be realized now and
therefore relevant cash flow for project evaluation.
Recognize the Investment in Working Capital

Common Mistakes
1. Forgetting the working Capital entirely-Initial investment in Working
Capital (outflow)
2. Forgetting that WC may change during the life of the project- Ex.
Change in Accounts Receivable
3. Forgetting that working Capital can be recovered at the end of the
project- Release of Working Capital or the disinvestment.

Remember the Terminal Cash Flows

Ex. – Disposal Value of the Equipment
-- Rehabilitation Costs for environment after the Mining Activities

Beware of Allocated Overhead

Ex. -- Allocated Administrative Expenses
Discount Nominal Cash Flow by the Nominal Cost of Capital

• Consistency --- Nominal Cash flow @ nominal interest rate

--- real Cash flow @ real discount rate

Consideration of Inflation
1+ real rate= 1+ nominal rate/ 1+ inflation rate
Example:
Given:
Annual lease payments (paid in advance) = 8,000
Annual inflation Rate= 3%
Lease term= 4 years
Discount rate= 10%
Solution:
Real discount rate = 1.10/1.03-1= .06796= 6.796%
Present Value= PVOA in advance @ real discount rate* annual
cashflow
= 3.634*8000
= 29,072
Separation of Investment & Financing
Decisions

• When valuing a project, ignore how the

project is financed.
• Regardless of the actual financing, you
should always view the project as if it
were all equity financed, treating all
cash outflows require for the project
coming from stockholders and all cash
inflows going to them.
 Calculating Cash flow
3 Elements
Cash flow from Capital investments
+ Operating Cash flows
+ cash flows from changes in Capital

Operating Cash Flows:

Method 1: Operating Cash Flows= Revenues -
Cash expenses - Taxes
Method 2: Operating Cash Flows= net profit +
Deprecation

Method 3: Operating Cash Flows= (revenues-cash

expenses)* (1-Tax rate) + (depreciation *tax rate)

Tax Shield

Modified Acceleration Cost Recovery System- Depreciation method that allows higher
deductions in earlier years and lower in later.
Operating Cash Flow?

Revenues P1000
-Cash Expenses 600
-Depreciation 200
Profit before tax 200
-tax@35% 70
Net Profit P 130