Fundamentals of Corporate Finance Third edition Chapter 7 Using Brealey Myers Marcus Discounted Cash Flow ndamentals of Corporate Finan Analysis to Make Investment Decisions Brealey Myers Marcus slides by Matthew will IrwinMcGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 1 Irwin/McGraw-Hill Chapter 7 Fundamentals of Corporate Finance Third Edition Using Discounted Cash Flow Analysis to Make Investment Decisions Brealey Myers Marcus slides by Matthew Will Irwin/McGraw-Hill ©The McGraw-Hill Companies, Inc.,2001
7-2 Topics Covered dIscounted Cash flows. Net Profits INcremental Cash flows s Treatment of Inflation SEparation of Investment Financing Decisions EXample: Blooper Industries Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 2 Irwin/McGraw-Hill Topics Covered Discounted Cash Flows, NetProfits Incremental Cash Flows Treatment of Inflation Separation of Investment & Financing Decisions Example: Blooper Industries
7-3 Cash Flow Vs Accounting Income s Discount actual cash flows O 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 NPy using cash flow to the NPv using accounting income Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 3 Irwin/McGraw-Hill 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
7-4 Cash Flow Vs 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) Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 4 Irwin/McGraw-Hill Year 1 Year 2 Cash Income $1500 $ 500 Depreciation -$1000 -$1000 Accounting Income + 500 - 500 Accounting NPV = 500 1.10 + − = 500 110 32 2 ( . ) $41. Cash Flow vs. Accounting Income
7-5 Cash Flow Vs Accounting Income Today Year 1 Year 2 Cash Income $1500$500 Project Cost 2000 Free Cash flow -2000 +1500 +500 20001500500 Cash npv $22314 1.10(10)2(1.10) Irwin/McGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 5 Irwin/McGraw-Hill Today Year 1 Year 2 Cash Income $1500 $ 500 Project Cost - 2000 Free Cash Flow - 2000 +1500 + 500 Cash NPV = - 2000 1.10 + + = − 1500 110 500 110 14 2 3 ( . ) ( . ) $223. Cash Flow vs. Accounting Income
7-6 Incremental Cash Flows s Discount incremental cash flows s Include all indirect effects o Forget Sunk costs S Include Opportunity Costs S Recognize the Investment in Working Capital s Beware of Allocated Overhead Costs Incremental cash flow cash flow Cash Flow with project without project Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 6 Irwin/McGraw-Hill Incremental Cash Flows Discount incremental cash flows Include All Indirect Effects Forget Sunk Costs Include Opportunity Costs Recognize the Investment in Working Capital Beware of Allocated Overhead Costs Incremental Cash Flow cash flow with project cash flow = without project -
7-7 Incremental Cash Flows IMPORTANT Ask yourself this question Would the cash flow still exist if the project does not exist? SIf yes, do not include it in your analysis SIf no. include it Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 7 Irwin/McGraw-Hill Incremental Cash Flows IMPORTANT Ask yourself this question Would the cash flow still exist if the project does not exist? If yes, do not include it in your analysis. If no, include it
7-8 Inflation INFLATION RULE DBe consistent in how you handle inflation yUse nominal interest rates to discount nominal cash flows SUse real interest rates to discount real cash flows S You will get the same results, whether you use nominal or real figures Irwin/McGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 8 Irwin/McGraw-Hill Inflation INFLATION RULE 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
7-9 Inflation Example You own a lease that will cost you $8,000 next year, increasing at 3%o 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 Irwin/McGraw-Hill CThe McGraw-Hill Commpanies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 9 Irwin/McGraw-Hill Inflation Example You own a lease that will cost you $8,000 next year, 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
7-10 Inflation Example- nominalfigures Year Cash Flow PV@10 8000 以11272.73 000 8000X1.03=8240 1/03≈680992 8240 8000x1.032=8240 848720=6376.56 4 8000x1.033=8487.20 8741.82 10=5970.78 $2642999 Irwin/McGraw-Hill CThe McGraw-Hill Companies, Inc, 2001
©The McGraw-Hill Companies, Inc.,2001 7- 10 Irwin/McGraw-Hill Inflation Example - nominal figures Year Cash Flow PV @ 10% 1 8000 2 8000x1.03 = 8240 8000x1.03 = 8240 8000x1.03 = 8487.20 8000 1.10 2 3 = = = = 7272 73 6809 92 3 6376 56 4 5970 78 429 99 8240 1 10 8487 20 1 10 8741 82 1 10 2 3 4 . . . . $26, . . . . .
