Lecture 3

Lecture 3
Corporate Finance
70-495
Spring 2018
Prof. Matthew Denes

Carnegie Mellon University
January 23, 2018
Prof. Matthew Denes (Carnegie Mellon University) Lecture 3 January 23, 2018 1 / 39
Reminders
• Groups for cases and project:

I Due yesterday
I Notified of group case in-class presentation schedule by tomorrow
• Problem Set 1:
I Available by the end of today and due on January 30
• Group Case 1:
I Case questions available on Thursday
I Covered in class on February 1
I Will discuss details next class
I Coursepack available in the bookstore
Corporate Finance Word of the Day
Big Mac Index
• Created by The Economist in 1986
• Compares price in US dollars of Big Mac in

different countries
• Based on idea of Purchasing power parity (PPP):
I Exchange rates should adjust so that the price (in the
same currency) should be equalized for the same good
I Big Mac is standardized across countries
Corporate Finance Word of the Day
Most Recent Index

• Suggests which
currencies are overvalued
or undervalued
• Currencies might not
adjust because of
untradable inputs, such as
rent and wages
• Updated annually at
Economist’s Big Mac
Index
• The Economist is a great
resource for weekly
international and domestic
business and political
news
Quick Review
Quick Review
(1) What is a debt covenant?
(2) Are debt covenants more common in companies

with high or low credit ratings?
Quick Review
Quick Review
(3) What is the difference between the IRR and

opportunity cost of capital?
(4) True or false: Using the NPV and IRR rules lead
to the same investment decisions
Capital Budgeting
Roadmap for the Next Few Classes
• Investment Criteria
• Capital Budgeting
I Calculate free cash flows and evaluate projects
• Project Analysis
I Sensitivity, scenario and break-even analysis
I Monte Carlo simulation
I Real options
• Group Case 1
I Apply these tools to a real-world example
Capital Budgeting
Plan for Today
I Incremental Cash Flows
I Inflation
I Cash Flows vs. Earnings
I Project Example
Textbook readings:
• Chapter 6 details capital budgeting
Capital Budgeting Investment Criteria
Investment Criteria
(1) Net present value (NPV)

NPV = PV (payoffs) − PV (costs) = Tt=0 (1+r CFt
P
I
)t
I Invest in project if its NPV is positive: NPV>0
(2) Internal rate of return (IRR)

I Discount rate such that NPV = 0
I Invest in project if its IRR is greater than the opportunity
cost of capital
(3) Payback rule

I Accept the project if the initial investment is recoverable
within some specified cutoff period
Free Cash Flows
• Cash flows from project are critical component for

each investment decision
• Where do project cash flows come from?
• Focus on free cash flows (FCF): Amount of
after-tax cash flow generated by project
I FCFt = (Revenuest − Costst − Depreciationt ) × (1 − τ )
+Depreciationt − ∆NWCt − Capital Expenditurest
I τ = Corporate tax rate on earnings
I ∆NWCt = Change in net working capital
Plan for Today
I Inflation
I Project Example
Textbook readings:
Capital Budgeting Incremental Cash Flows
Incremental Cash Flows
• When making an investment decision or

evaluating a project:
I Focus on cash flows from project and when
they occur
I Consider the incremental (or marginal) effects
of the project (relative to those without project)
I Remember any opportunity costs
I Be consistent with units
I Present vs. future values, nominal vs. real, $ vs. e
Depreciation
• Depreciation is a non-cash item, so why does it
matter for project evaluation?
• Capital expenditures reduce taxes based on the
investment’s depreciation schedule
I Commonly referred to as tax shields
• Types of depreciation:
I Straight-line
I Modified Accelerated Cost Recovery System (MACRS)
(see Table 6.4 in textbook)
• Would a company prefer for depreciation to be

taken using straight-line or MACRS?
Opportunity Costs
• Forgone cash flows that are lost if the project is
undertaken
• Relevant comparison is cash flow with or without
project (not before versus after)
• Opportunity costs include:
I Rental income or revenue from selling property
(whichever is higher)
I Previously purchased equipment used for project
I Cannibalized profits from other parts of branches or
nearby stores
• If resource is freely traded, use the market price

Sunk Costs
• Forget sunk costs!
• Past and irreversible outflows
• Not incremental to the investment decision, since

they have already been incurred
• Sunk cost fallacy:

I Any decision that is made based on previously invested
resources (time, money, effort)
I More general than project evaluation!
Sunk Cost Fallacy
• NY Jets and their quarterback, Mark Sanchez, had a bad 2012 season
• After the season, they fired some of their coaching staff
• “But the Jets have invested an enormous amount of energy and money
in Sanchez, and, assuming that no one will trade for him, they are
contracted to pay him $8.25 million next year, whether he plays or not.”
• What should the Jets do?
• “. . . while the Jets figure out whether Sanchez is the best option, they
need to forget–forget how much they’ve paid him, how high he was
drafted, and even the fact that the head coach has a tattoo of his wife
wearing Sanchez’s jersey. All those costs are sunk. Worrying about
them will only insure that the Jets are, too.”
Overhead Expenses
• Overhead expenses include supervisory salaries,

rent, heat and light
• How should overhead expenses be allocated to
the project?
• Accountants might want to find ways to allocate
overhead to project
• Remember incremental cash flows: only include
extra expenses incurred because of the project
Terminal Values
• Additional cash flows at the end of the project
I Cash inflows could include selling equipment or land,
collecting outstanding account receivables or selling
remaining inventory
I Cash outflows could include shutdown costs
• Salvage value:
I Book value of an asset equals initial investment minus
its cumulative depreciation
I Tax consequences if sale price of assets does not equal
its book value:
I If you sell an asset and the sales price is above the book
value, the difference constitutes a taxable book gain
I If you sell an asset and the sales price is below the book
value, the difference constitutes a book loss, which gives rise
to a tax credit
Net Working Capital

• Net working capital (NWC) is the difference
between short-term assets and short-term
liabilities
I Principal short-term assets are accounts receivable and
inventories of raw materials and finished goods
I Principal short-term liabilities are accounts payable
• Changes in NWC are a cash flow (not NWC itself)

I NWC is not a “flow” but a“stock”!
I Increase in NWC are firm’s cash outflows
I Decreases in NWC are firm’s cash inflows
• NWC is often recovered at the end of the project

NWC Example
A project starts in 2019 and lasts for four years.

($ thousands) 2019 2020 2021 2022 2023
Accounts receivable 0 150 225 190 0
Inventory 75 130 130 95 0
Accounts payable 25 50 50 35 0
Calculate the net working capital for this project.
Corporate Taxes
• Corporate taxes (τ ) were often considered

to be 35%
• Recent tax law lowered this rate to 21%
• What rate should we consider for the project?
I Marginal tax rate incurred by project
I This might vary depending where the project takes
place
• What is the effect of lowering the corporate tax

rate from 35% to 21%, holding all else constant?
Investment and Financing Decisions
• Treat investment and financing decisions

separately
• First, determine if the project has a positive NPV
I Do not consider financing cash flows such as interest
on debt issued for project
• Next, decide on optimal financing strategy

I We will return to this when we discuss financing and
valuation (Ch. 19)
Plan for Today
I Inflation
I Project Example
Textbook readings:
Capital Budgeting Inflation
Inflation
• Inflation refers to the rise in the general price level as

measured against a standard level of purchasing power
• There is inflation (deflation) when the quantity of
consumption goods that a fixed amount of money can buy
decreases (increases) over time
• Be consistent in your treatment of inflation!
I Use a nominal discount rate to discount nominal cash
flows
I Use a real discount rate to discount real cash flows
• The nominal approach is often preferable, since returns

from financial markets are nominal
What’s Real?
Real Measured in units of account with a

constant purchasing power
Nominal Measured in units of account with
purchasing power that depends on inflation
• Examples:
I Lease: Nominal
I Estimates of costs from an engineer: Often these will
be real
I Tax savings from depreciation: Nominal
Relation between Nominal and Real Cash Flows
• Can use inflation to convert cash flows into real terms

• Can also use real discount rate:
1 + Nominal discount rate
Real discount rate = −1
1 + Inflation rate
• Never mix cash flows and discount rates between nominal
and real terms
• Similar conversions necessary for cash flows in different
currencies
Inflation Example
• Suppose that the nominal discount rate is 12%
and inflation is 5%
• Consider the following project cash flows:
Cash Flows
0 1 2
−100 70 60
• Find the NPV using nominal cash flows and the

nominal interest rate
• Find the NPV using real cash flows and the real
interest rate
Plan for Today
I Inflation
I Project Example
Textbook readings:
Capital Budgeting Cash Flows vs. Earnings
Cash Flows vs. Earnings
• Focus on free cash flows (FCF) from projects

I Difference between cash received and cash paid out
• Accounting measures a firm’s earnings or

performance
• Earnings might be recorded in different periods
than when cash flows occur
I For example, capital expenditures could happen at the
start of the project, but are often deducted in several
periods for accounting measures
Cash Flows vs. Earnings

• In valuation, we use cash flows rather than
earnings
I You cannot spend earnings!
• Principles governing accounting earnings
measurement:
I Show revenues when products and services are sold or
provided, not when they are paid for
I Show expenses associated with these revenues rather
than cash expenses
I Only expenses associated with creating revenues in the
current period should be treated as operating expenses
I Expenses that create benefits over several periods are
written off over multiple periods (depreciation)
Finance vs. Accounting
Plan for Today
I Inflation
I Project Example
Textbook readings:
Capital Budgeting Project Example
Project Example
Your company is considering a 3-year contract to roast coffee in Pittsburgh.

The equipment needed would cost $50,000 and would be depreciated on a
5-year straight line basis to zero. You could sell the equipment at the end of
the contract for $24,000. You will also use some existing equipment with a
book value of zero and a market value of $10,000. Your company’s vice
president of operations would supervise production along with her other
duties. Her salary is $120,000 per year. The cost of roasting the coffee
would be $200,000 per year. The revenues are expected to be $225,000 per
year. New working capital for production will be $20,000 immediately.
Project working capital will stay level at $20,000 in year 1, decrease to
$10,000 in year 2 and then drop to 0 at the end of the project. Your discount
rate is 10% and your tax rate is 21%. Calculate the free cash flows for the
project and compute the project’s NPV.
Recap
• Incremental cash flows
I Tax shields from depreciation
I Include opportunity costs
I Forget sunk costs
I Only include incremental overhead expenses
I Consider terminal values, such as salvage value
I Calculate cash flows from changes in net working
capital
I Deduct corporate taxes
I Do not include financing cash flows
• Use nominal discount rate with nominal cash
flows, and real discount rate with real cash flows
• Cash flows are important for project evaluation,
not earnings
Problem Sets
• Apply concepts from class and practice for exams

• Completed individually, clearly written and show
your work
I Include spreadsheet printout for any problems
completed in Excel
• Due at the beginning of class

I Late submissions not accepted after class starts,
unless you are sick and have a doctor’s note
• Solutions will be posted on Canvas
Problem Set 1
• Covers the first four lectures

• Junk bonds are rated BB or lower (S&P & Fitch
ratings)
• IRR calculations can be completed in Excel, or
using your calculator
• Show your work!
I Provide equation solved
I Include spreadsheet, when relevant
Coming Up on Thursday
• Project Analysis
• Problem Set 1:
I Available by the end of today and due on January 30
• Group Case 1:
I Case questions available on Thursday
I Covered in class on February 1
I Will discuss details next class
I Coursepack available in the bookstore
Textbook readings:
• Chapter 10 reviews project analysis

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Lecture 3

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Lecture 3

Prof. Matthew Denes

January 23, 2018

• Groups for cases and project:

Big Mac Index

• Created by The Economist in 1986

• Compares price in US dollars of Big Mac in

Most Recent Index

(1) What is a debt covenant?

(2) Are debt covenants more common in companies

(3) What is the difference between the IRR and

Roadmap for the Next Few Classes

Plan for Today

(1) Net present value (NPV)

(2) Internal rate of return (IRR)

(3) Payback rule

Free Cash Flows

• Cash flows from project are critical component for

Plan for Today

Incremental Cash Flows

• When making an investment decision or

• Would a company prefer for depreciation to be

• If resource is freely traded, use the market price

• Forget sunk costs!

• Past and irreversible outflows

• Not incremental to the investment decision, since

• Sunk cost fallacy:

Sunk Cost Fallacy

• Overhead expenses include supervisory salaries,

Net Working Capital

• Changes in NWC are a cash flow (not NWC itself)

• NWC is often recovered at the end of the project

A project starts in 2019 and lasts for four years.

Calculate the net working capital for this project.

• Corporate taxes (τ ) were often considered

• What is the effect of lowering the corporate tax

Investment and Financing Decisions

• Treat investment and financing decisions

• Next, decide on optimal financing strategy

Plan for Today

• Inflation refers to the rise in the general price level as

• The nominal approach is often preferable, since returns

Real Measured in units of account with a

Relation between Nominal and Real Cash Flows

• Can use inflation to convert cash flows into real terms

• Find the NPV using nominal cash flows and the

Plan for Today

Cash Flows vs. Earnings

• Focus on free cash flows (FCF) from projects

• Accounting measures a firm’s earnings or

Cash Flows vs. Earnings

Finance vs. Accounting

Finance vs. Accounting

Finance vs. Accounting

Plan for Today

Your company is considering a 3-year contract to roast coffee in Pittsburgh.

• Apply concepts from class and practice for exams

• Due at the beginning of class

• Solutions will be posted on Canvas

• Covers the first four lectures

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