GRADUATE SCHOOL OF UNIVERSITY OF THE EAST – MANILA

Report

On

Corporate Finance

“Using Discounted Cash Flow Analysis to Make Investment Decisions”

Submitted to:
Dr. Milagros Clemente

Submitted by:
Sheena Rhei T. Del Rosario
Masters in Accountancy Major in Management Accounting

Date of Submission:
August 17, 2019
Learning Objectives:
 Identify the cash flows attributable to a proposed new project.
 Calculate the cash flows of a project from standard financial statements.
 Understand how the company’s tax bill is affected by depreciation and project value.
 Understand how changes in working capital affect project cash flows.
Introduction
In this topic, I will discuss how to “spread the numbers” for a proposed investment or
project and, based on those numbers, make an initial assessment about whether or not the
project should be undertaken. I’ll focus on the process of setting up a discounted cash flow
analysis.
In evaluating a proposed investment, we pay special attention to deciding what
information is relevant to the decision at hand and what information is not. As we shall see, it
is easy to overlook important pieces of the capital budgeting puzzle. I’ll describe in detail how
to go about evaluating the results of our discounted cash flow analysis.
Definition of Discounted Cash Flow Analysis
In simple words, Discounted Cash Flow or DCF analysis is a process of evaluating the
attractiveness of an investment opportunity in the future at present. As such, discounted cash
flow valuation analysis tries to calculate the value of a company today, based on forecasts of
how much money the company is going to make in the future.
In other words, DCF analysis uses the forecasted free cash flows of a company and
discount them back so as to arrive at the present value estimate, which forms the basis for the
potential investment now. The core concept of the DCF is that of the basic finance concept of
the time value of money, which states that money is worth more in the present than the same
amount in the future. In other words, a peso today is worth more than a peso tomorrow.

Discounted Cash Flow Valuation Analogy

Let us take a simple discounted cash flow example. If you have an option between
receiving P10,000 today and obtaining P10,000 in a year time. Which one will you take?

Here, the chances are more than you will consider taking the money now because you
can invest that P10,000 today and earn more than P10,000 in the next twelve months’ time.
Obviously, you considered the money today because the money available today is worth more
than the money in the future due to its potential earning capacity (time value of money concept).

The idea behind the time value of money is that if you have to wait to receive your
funds, you’re missing out on other potential investment opportunities, not to mention the risk
of not receiving the money at all. If you have to wait to get your money, you’d expect some
compensation — hence, the concept of interest.
For example, if you invest P10,000 at a 10 percent annual interest rate today, it will be
worth P11,000 in one year. Conversely, P11,000 in one year would only be worth P10,000
today. In this example, the 10 percent is referred to as the discount rate. As the name suggests,
the discount rate is a key input you need to calculate the DCF.
Identifying the Relevant Cash Flows

 The first step in capital budgeting is to identify the relevant cash flows.
o The effect of taking a project is to change the firm’s overall cash flows today
and in the future. To evaluate a proposed investment, we must consider these
changes in the firm’s cash flows and then decide whether or not they add value
to the firm. The first (and most important) step, therefore, is to decide which
cash flows are relevant and which are not.

 Two rules can help you in identifying relevant cash flows:

1. Capital budgeting decisions must be based on cash flows, not accounting
income.
2. Only incremental cash flows are relevant.

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.

Year 1 Year 2

Cash Income $1500 $500

Depreciation -$1000 -$1000
Accounting Income + 500 - 500

Accounting NPV = 500 + -500 = $41.32

1.10 (1.10)2

Today Year 1 Year 2

Cash Income $1500 $ 500

Project Cost - 2000__________________

Free Cash Flow - 2000 +1500 + 500

Cash NPV = - 2000 + 1500 + 500 = -$223.14

1.10 (1.10)2 (1.10)3

Incremental Cash Flows – represent the change in the firm’s total cash flow that occurs as a
direct result of accepting a project.
 Incremental Cash Flow = cash flow with project - cash flow without project

Incremental cash flow analysis is used to review a change in the cash inflows and
outflows that are specifically attributed to a management decision. As an example, if a
business is considering altering the amount of production capacity of a machine, the
decision should be made based on the incremental cash outflows required to alter the
capacity of the equipment, as well as the incremental cash inflows resulting from that
decision. There is no need to consider the aggregate cash flows associated with all
operations of the machine.

The analysis may be based on a variety of cash flows, such as the initial outlay of cash,
ongoing inflows and outflows related to the maintenance, operations, and net receipts from
the project, and any cash flows associated with the eventual termination of the project
(which includes both cash inflows from sale of the equipment and cash outflo ws for
remediation costs).

• Incremental Cash Flow Example

For example, ABC International owns a machine that can manufacture 2,000 units
per hour. An equipment upgrade can change the maximum capacity of the machine
to 3,000 units per hour, which is an incremental increase of 1,000 units. The cost
of this upgrade is $200,000, and the profit derived from each unit is $0.10. The
machine is currently operated for 40 hours per week, so the contemplated increase
in capacity will yield a net incremental cash flow increase per year of $208,000.
The calculation is:

(1,000 units per hour) x $0.10 = $100 per hour incremental cash inflow

= ($100 per hour of cash inflow) x (40 hours per week) x (52 weeks per year)

= $208,000

The incremental change in cash flow represents a payback period of just over 1.0
years, which is highly acceptable as long as the upgraded equipment can be
expected to operate for longer than the payback period.

Sunk Costs

A sunk cost is a cost we have already paid or have already incurred the liability to pay.
Such a cost cannot be changed by the decision today to accept or reject a project. Put another
way, the firm will have to pay this cost no matter what. Based on our general definition of
incremental cash flow, such a cost is clearly not relevant to the decision at hand. So, we will
always be careful to exclude sunk costs from our analysis.

Opportunity Costs

Opportunity Costs are cash flows that could be generated from an asset the firm already owns
if it is not used for the project in question.

Suppose the plant space could be leased out for $25,000 a year. Would this affect the
analysis?

- Yes. Accepting the project means we will not receive the $25,000. This is an
opportunity cost and it should be charged to the project.

Externalities (Indirect Effects)

If the new product line would decrease sales of the firm’s other products by $50,000 per year.
Would this affect the analysis?

- Yes. The effects on the other project’s cash flows are called as externalities. Net Cash
flow losses per year on other lines would be a cost to a project. Externalities will be
positive if new projects are complements to existing assets. Negative, if they are
substitutes.

(Illustration of Incremental Cash Flow)

Net Working Capital

Normally, a project will require that the firm invest in net working capital in addition
to long-term assets. For example, a project will generally need some amount of cash on hand
to pay any expenses that arise. In addition, a project will need an initial investment in
inventories and accounts receivable (to cover credit sales). Some of the financing for this will
be in the form of amounts owed to suppliers (accounts payable), but the firm will have to
supply the balance. This balance represents the investment in net working capital. It’s easy to
overlook an important feature of net working capital in capital budgeting. As a project winds
down, inventories are sold, receivables are collected, bills are paid, and cash balances can be
drawn down. These activities free up the net working capital originally invested. So, the
firm’s investment in project net working capital closely resembles a loan. The firm supplies
working capital at the beginning and recovers it towards the end.

Inflation

 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.

• Example: You are considering moving into a new office, which will cost you $8,000
for one year (you should pay it immediately), 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

• Example - nominal figures:

Year Cash Flow PV @ 10%

0 8000 8,000

1 8000x1.03 = 8240 7,490.91 (8240/1.10)

2 8000x1.032 = 8487.20 7,014.22 (8487.20/1.102 )

3 8000x1.033 = 8741.82 6,567.86 (8741.82/1.103 )

$29,072.98
 • Example - real figures

Year Cash Flow PV @ 10%

0 8,000 8,000

1 8,000 7,490.91 (8000/1.068)

2 8,000 7,014.22 (8000/1.0682 )

3 8,000 6,567.86 (8000/1.0683 )

$29,072 .98

Separation of Investment & Financing Decisions

• When valuing a project, ignore how the project is financed (exclude interest expense
from cash flow).
• We discount a project’s cash flows by its WACC. This Weighted Average Cost of
Capital is the rate of return necessary to satisfy all of the firm’s investors, both
stockholders and debtholders. As the cost of debt is already embedded in the WACC,
subtracting interest payments from the project’s cash flows would be a mistake.

Calculating Cash Flow:

• Total Cash Flow = Cash Flow from Investment in Plant & Equipment + Cash Flow
from Investments in Working Capital + Cash Flow from Operations

• Sample Problem 1: Bloopers Industry

Cash Flow From Operations

Revenues 15,000
Expenses (10,000)
Depreciation (2,000)
Profit before tax 3,000
Tax @ 35 % (1,050)
Net profit 1,950
Depreciation 2,000
CF from operations 3,950

• Net Cash Flows (entire project)

NPV @ 12% = $4,222,350

 Sample Problem 2:
Old equipment: book value = $600,000 with a remaining life of 5 years
Expected salvage value in 5 years = 0
Market value today = $265,000
Straight-line depreciation

New equipment: purchase price = $1,175,000 and a MACRS life of 5 years

Expected salvage value in 5 years = $145,000
Annual savings = $255,000

Other information: 40% marginal tax rate and a 12% hurdle rate

Step 1: Incremental Cash Flows

DCF = (DS - DC - DD)(1 - t) + DD

Let's first find DD. The depreciation on the old equipment is easy since it's straight-line.

D = 600000/5 = 120000 per year. The new machine is being depreciated using MACRS and
it's in the 5 year class. Look in the text for a table of the percentages to use each year. For a 5
year asset, the percentages are 20%, 32%, 19%, 12% and 11%. That's a total of 94%. That
means the book value at the end of the 5th year is 6%. Remember, with MACRS a 5 year asset
really means 5.5 years and the remaining 6% is a half year's depreciation. Applying these rates
to the price of 1,175,000 gives the following annual depreciation for the new equipment:
.20*1,175,000 = 235,000; .32*1,175,000 = 376,000; .19*1,175,000 = 223,250; .12*1,175,000
= 141,000; .11*1,175,000 = 129,250 with a remaining book value of .06*1,175,000 = 70,500.
Merely subtract the depreciation on the old equipment of $120,000 from the depreciation on
the new equipment to get each year's DD.

YEAR Dnew Dold DD

1 235,000 120,000 115,000
2 376,000 120,000 256,000
3 223,250 120,000 103,250
4 141,000 120,000 21,000
5 129,250 120,000 9,250
We now can compute the incremental cash flows for each year by using the equation DCF =
(DS - DC - DD)(1 - t)+ DD where DS = 0, DC = -255,000 and DD is obtained from the above
table. For year 1 DCF = (0 -(-255,000) - 115,000)*(1 - .40) + 115,000 = 199,000. Repeat the
process for the other 4 years.
YEAR DCF
1 199,000
2 255,400
3 194,300
4 161,400
5 156,700
In the terminal fifth year, lots of special things often happen. First is the return of any
incremental net-working-capital. In this problem, there isn't any, so forget it. Usually you need
to include the return of any net-working-capital as a cash inflow.

What can the old machine be sold for? Zero. So forget that, too. Usually you need to include
any proceeds from selling the old machine as a cash inflow. Since the old machine is being
depreciated using straight-line, it is being depreciated to its predicted salvage value. Thus, for
nearly all problems, when using straight-line the machine's predicted market value and its book
value will both equal the expected salvage value and, hence, there won't be any tax effect. But
in this problem, the expected salvage value and the book value are both 0.

The new machine can be sold for $145,000 but its book value at the end of the 5th year is
70,500. Whenever any machine is sold for a price other than its book value, there is a tax effect
that you must consider. This could pertain to the old machine or the new machine. The net
proceeds from the sale is always MV - t(MV - BV). Be careful of the signs--but this always
works. In this example, 145,000 - .4*(145,000 - 70,500) = 115,200. In the fifth year, there is
this cash inflow of 115,200 from selling the new machine. This will make the total cash flows
in the firth year 115,200 (nonoperating) + 156,700 (operating) = 271,900. Now let's solve for
the initial outlay.

Step 2: Initial Outlay

The initial outlay usually has three parts: cost of the new machine, the proceeds from selling
the old machine (if there is one) and any additional net-working-capital that must be raised for
the project. In this problem, the new machine has a purchase price of $1,175,000. There is no
additional net-working-capital to be raised. If there were any, you would add it to the outlay.
The proceeds from selling the old machine is usually the most complicated. In the example, it
can be sold for $265,000 which is a lot less than its current book value of $600,000. Let's use
the formula we just talked about: net proceeds = MV - t(MV - BV). Here it's 265,000 -
.4*(265,500 - 600,000) = 399,000. There is a big capital loss on the sale (suggesting that it
hasn't been depreciated enough to this point and the IRS is giving them some of the loss back).
The firm will come away from the sale with $399,000. This will lower the outlay for the new
machine to 1,175,000 - 399,000 = 776,000. Same formula as we used in the section above for
the terminal cash flow, only this time we apply it to the sale of the old machine. Above we
applied it to the sale of the proposed new machine 5 years from now when it is scrapped.

It's the same formula and it's applied for the exact same reason: you're selling a machine at a
market value different from its book value. You gotta pay additional taxes if it's a gain and you
get a tax refund if the sale is at a loss. There's another way of looking at the tax effect on the
proposed new machine. Let's pretend that the firm buys the proposed new machine today and
the forecasts all hold. 5 years from now they are considering buying another proposed new
machine and you need to consider the initial outlay of that purchase. The "old" machine (the
one you bought today) has a book value of 70,500. It can be sold for 145,000. The net proceeds
is equal to 145,000 - .4*(145,000 - 70,500) = 115,200. Exactly what you did in the cash flow
section above but then it was the "new" machine being sold 5 years from now. In this section
it has now become the "old" machine and it is being sold 5 years from today because the firm
is considering buying a third machine.

Now let's combine the answers from Steps 1 and 2 to see if the replacement is worthwhile.

Step 3: NPV and IRR

Here's a table of our cash flows:

YEAR DCF
0 -776,000
1 199,000
2 255,400
3 194,300
4 161,400
5 271,900
The formula for NPV is:

NPV = - outlay + DCF1/(1 + k)1 + DCF2/(1 + k)2 + ... + DCFn/(1 + k)n

NPV = - 776,000 + 199,000/(1.12)1 + 255,400/(1.12)2 + 194,300/(1.12)3 + 161,400/(1.12)4 +

271,900/(1.12)5

NPV = 436.77 acceptable

The formula for IRR is:

0 = - outlay + DCF1/(1 + r)1 + DCF2/(1 + r)2 + ... + DCFn/(1 + r)n

where r is the IRR of the project.

0 = - 776,000 + 199,000/(1 + r)1 + 255,400/(1 + r)2 + 194,300/(1 + r)3 + 161,400/(1 + r)4 +
271,900/(1 + r)5

r = 12.02% acceptable

We knew it was going to be slightly larger than 12% because when we calculated the NPV
using 12%, it was a very small $436.77.

 Practical Application: How to Value a Project?

A lot of businesses use discounted cash flow analysis to determine which projects to
invest in. They have a finite amount of money to spend each year, so they want to put it into
the projects that are expected to result in the highest rate of return. They don’t just want to
throw darts at a dartboard and see what sticks.

Companies usually use their weighted-average cost of capital (WACC) as their discount
rate, which takes into account the average rate of return that their stock and bond holders
expect.

Suppose you’re a financial analyst at a company, and you are recommending whether
the company should invest in Project A or Project B.

Each of the two projects has been proposed by a lead engineer, but the company can
only invest in creating one of them this year, and so your manager wants you to give her advice
on which one to invest in. Your company’s WACC is 9%, so you’ll use 9% as your discount
rate.

Here are the two projects:

Project A starts with an initial investment to make a tech product, followed by a growing
income stream, until the product becomes obsolete and is terminated.

Project B starts with an initial investment to make a different product, and makes no sales, but
the whole product is expected to be sold in five years to some other company for a large payoff
of $14 million.

Which project, assuming both carry the same risk, should the financial analyst recommend to
her manager?

First, let’s analyze the discounted cash flows for Project A:

The sum of the discounted cash flows (far right column) is $9,707,166.

Therefore, the net present value (NPV) of this project is $6,707,166 after we subtract the $3
million initial investment.

Now, let’s analyze Project B:

The sum of the discounted cash flows is $9,099,039.

Therefore, the net present value (NPV) of this project is $6,099,039 after we subtract the $3
million initial investment.

We can conclude that from a financial standpoint, Project A is better, since it has a higher net
present value.
Even though Project B will bring in $14 million in cash over its lifetime and Project A will
only bring in $12 million, Project A is more valuable because of the earlier timing of those
expected cash flows.

Thus, you should advise your manager to pick Project A to invest in for this year, if she can
only invest in one.

Of course, in the real world, there could still be circumstances that might lead to the manager
picking project B instead. There could be non-financial reasons to invest in that project, such
as assisting with long-term strategic positioning, or trying to enter a new market, or something
of that nature.

But in terms of which project is inherently more profitable assuming the cash flow expectations
are accurate, the answer is Project A.

Summary:

1.) How should the cash flows of a proposed new project be calculated?

Here is a checklist to bear in mind when forecasting a project's cash flows:

• Discount cash flows, not profits.
• Estimate the project's incremental cash flows—that is, the difference between the cash
flows with the project and those without the project.
• Include all indirect effects of the project, such as its impact on the sales of the firm's
other products.
• Forget sunk costs.
• Include opportunity costs, such as the value of land that you could otherwise sell.
• Beware of allocated overhead charges for heat, light, and so on. These may not reflect
the incremental effects of the project on these costs.
• Remember the investment in working capital. As sales increase, the firm may need to
make additional investments in working capital, and as the project finally comes to an
end, it will recover these investments.
• Treat inflation consistently. If cash flows are forecast in nominal terms (including the
effects of future inflation), use a nominal discount rate. Discount real cash flows at a
real rate.
• Do not include debt interest or the cost of repaying a loan. When calculating NPV,
assume that the project is financed entirely by the shareholders and that they receive all
the cash flows. This separates the investment decision from the financing decision.

2.) How can the cash flows of a project be computed from standard financial
statements?
- Project cash flow does not equal profit. You must allow for changes in working
capital as well as noncash expenses such as depreciation.
- Also, if you use a nominal cost of capital, consistency requires that you
forecast nominal cash flows—that is, cash flows that recognize the effect of
inflation.
 3.) How is the company's tax bill affected by depreciation, and how does this
affect project value?
- Depreciation is not a cash flow. However, because depreciation reduces taxable
income, it reduces taxes. This tax reduction is called the depreciation tax shield.
- The use of depreciation can reduce taxes that can ultimately help to increase net
income. Net income is then used as a starting point in calculating a company's
operating cash flow. Operating cash flow starts with net income, then adds
depreciation/amortization, net change in operating working capital, and other
operating cash flow adjustments. The result is a higher amount of cash on the cash
flow statement because depreciation is added back into the operating cash flow.
- Modified accelerated cost recovery system (MACRS) depreciation schedules allow
more of the depreciation allowance to be taken in early years than is possible
under straight-line depreciation. This increases the present value of the tax shield.
4.) How do changes in working capital affect project cash flows?
- Increases in net working capital such as accounts receivable or inventory are
investments and therefore use cash—that is, they reduce the net cash flow provided
by the project in that period. When working capital is run down, cash is freed up,
so cash flow increases.

 References:
- Fundamentals of Financial Management, 13th Edition, 2016 by Dr. Eugene Brigham
& Dr. Joel F. Houston
- Essentials of Corporate Finance 7th Edition (The McGraw-Hill/lrwin Series) 2011
- Fundamentals of Corporate Finance, 6th Edition, 2002 by Ross Westerfield Jordon
- https://www.slideshare.net/MunarbekKaarov/fm11-ch-11-show