Intermediate Finance

Session 4
 The missing ingredient …
• NPV, IRR and Payback use cash flows, but
how do you estimate cash flows?
The missing ingredient …
We are talking about …
CASH FLOWS NOT
ACCOUNTING INCOME
 Cash Flows NOT Accounting Income

• The Weber-Decker Co. just paid $1 million in cash for

a building as part of a new capital budgeting project.
This entire $1 million is an immediate cash outflow.
• Assuming straight-line depreciation over 20 years, only
$50,000 (5$1 million/20) is considered an accounting
expense in the current year. Current earnings are
thereby reduced by only $50,000. The remaining
$950,000 is expensed over the following 19 years.
• For capital budgeting purposes, the relevant cash
outflow at Date 0 is the full $1 million or $50,000?
 Cash Flows NOT Accounting Income

• The Weber-Decker Co. just paid $1 million in cash for a

building as part of a new capital budgeting project. This
entire $1 million is an immediate cash outflow.
• Assuming straight-line depreciation over 20 years, only
$50,000 (5$1 million/20) is considered an accounting
expense in the current year. Current earnings are thereby
reduced by only $50,000. The remaining $950,000 is
expensed over the following 19 years.
• For capital budgeting purposes, the relevant cash
outflow at Date 0 is the full $1 million, not the reduction
in earnings of only $50,000.
IT’S NOT ENOUGH TO USE
CASH FLOWS …
 NPV & Cash Flows
• In calculating the NPV of a project, only cash
flows that are incremental to the project
should be used.
• But what are incremental cash flows?
 NPV & Cash Flows
• Changes in the firm’s cash flows that occur
as a direct consequence of accepting the
project.
• We are interested in the difference between
the cash flows of the firm with the project
and the cash flows of the firm without the
project. (IMPORTANT)
• Easier said than done
Common Pitfalls
 Sunk Costs
• The General Milk Company (GMC) is
currently evaluating the NPV of establishing a
line of chocolate milk. As part of the
evaluation, the company paid a consulting firm
$100,000 last year for a test marketing
analysis. Is this cost relevant for the capital
budgeting decision now confronting GMC’s
management?
 Sunk Costs
• No! The $100,000 is not recoverable, so the
$100,000 expenditure is a sunk cost, or spilled milk.
• In other words, one must ask, “What is the
difference between the cash flows of the entire
firm with the chocolate milk project and the cash
flows of the entire firm without the project?”
• Since the $100,000 was already spent, acceptance of
the project does not affect this cash flow
 Opportunity Costs
• Zakir Tika owns land with a current market
value of $2 million that can be used for the new
Zakir Tika branch if it decides to build a new
branch. If Zakir Tika goes forward with the
project, only another $15 million will be
required, not the full $17 million, because it will
not need to buy the required land.
• Should Zakir Tika use the $15 million
incremental cost as the cost of the new branch?
 Opportunity Costs
• No ! If the new branch is not built, then
Zakir Tika could sell the land and receive a
cash flow of $2 million. This $2 million is an
opportunity cost—it is cash that it would not
receive if the land is used for the new branch.
• Therefore, the $2 million must be charged to
the new project, and failing to do so would
cause the new project’s calculated NPV to be
too high.
 Side Effects | Erosion
• A side effect is classified as either erosion or
synergy.
• Erosion occurs when a new product reduces
the sales and, hence, the cash flows of
existing products.
 Side Effects | Erosion
• Innovative Motors Corporation (IMC) is
determining the NPV of a new convertible
sports car. Some of the would-be purchasers
are owners of IMC’s compact sedans. Are all
sales and profits from the new convertible
sports car incremental?
 Side Effects | Erosion
• No! because some of the cash flow represents transfers
from other elements of IMC’s product line. This is
erosion, which must be included in the NPV calculation.
• Without taking erosion into account, IMC might
erroneously calculate the NPV of the sports car to be,
say, $100 million.
• If half the customers are transfers from the sedan and
lost sedan sales have an NPV of -$150 million, the true
NPV is -$50 million ($100 million - $150 million).
 Side Effects | Synergy
• IMC is also contemplating the formation of a racing team.
The team is forecast to lose money for the foreseeable future,
with perhaps the best projection showing an NPV of -$35
million for the operation.
• IMC’s managers are aware that the team will likely generate
great publicity for all of IMC’s products.
• A LUMS graduate estimates that the increase in cash flows
elsewhere in the firm has a present value of $65 million.
• Assuming that LUMS graduate’s estimates of synergy are
trustworthy, the net present value of the team is $30 million
($65 million - $35 million). The managers should form the
team. (Any other example in a Pakistani context?)
 Allocated Costs
• Frequently a particular expenditure benefits a
number of projects.
• Accountants allocate this cost across the
different projects when determining income.
• However, for capital budgeting purposes, this
allocated cost should be viewed as a cash
outflow of a project only if it is an incremental
cost of the project.
 Allocated Costs
• Islamic Development Bank Jeddah devotes one wing
of its suite of offices to a library requiring a cash
outflow of $100,000 a year in upkeep.
• A proposed capital budgeting project is expected to
generate revenue equal to 5 percent of the overall
bank’s revenues.
• CEO of the bank, argues that $5,000 (5 percent X
$100,000) should be viewed as the proposed project’s
share of the library’s costs.
• Is this appropriate for capital budgeting?
 Allocated Costs
• No! One must ask what the difference is between the
cash flows of the entire firm with the project and the
cash flows of the entire firm without the project.
• The firm will spend $100,000 on library upkeep
whether or not the proposed project is accepted.
• Because acceptance of the proposed project does
not affect this cash flow, the cash flow should be
ignored when calculating the NPV of the project.
Interest Rates & Inflation
Interest Rates & Inflation
Interest Rates & Inflation
 Cash Flows & Inflation
• Nominal cash flow refers to the actual dollars
to be received (or paid out).
• Real cash flow refers to the cash flow’s
purchasing power.
 Discounting: Nominal or Real?
• Nominal cash flows must be discounted at the
nominal rate
• Real cash flows must be discounted at the real
rate
• As long as one is consistent, either approach
is correct.
Alternative Definitions :
Operating Cash Flows
How do we determine …
OPERATING CASH FLOWS?
 Top-Down Approach
• Follow the cash
• The owner receives sales of $1,500, pays cash costs of
$700 and pays taxes of $68

• Start at the top of the income statement and work our

way down to cash flow by subtracting costs, taxes, and
other expenses.
• Why is deprecation not included?
 Bottom-Up Approach
• Start with the accountant’s bottom line (net
income) and add back any noncash
deductions such as depreciation.
• It is crucial to remember that this definition of
operating cash flow as net income plus
depreciation is correct only if there is no
interest expense subtracted in the
calculation of net income.
 Bottom-Up Approach
• Calculate Project Income

• Add Depreciation
 Tax Shield Approach
• Just a variant of the top-down approach
 Tax Shield Approach
• This approach views OCF as having two
components.
• First part is what the project’s cash flow
would be if there were no depreciation
expense. In our example, this would-have-
been cash flow is $528.
 Tax Shield Approach
• This approach views OCF as having two
components.
• Second part is the depreciation deduction
multiplied by the tax rate. This is called the
depreciation tax shield
Discounted Cash Flow Analysis
SOME SPECIAL CASES
 Special Cases
1. Cost-cutting investments (what’s so
special ?)
2. Competitive bidding (what’s so special ?)
3. Investments of Unequal Lives (what’s so
special ?)
 Cost-Cutting Proposals
• Firms must frequently decide whether to make
existing facilities cost-effective.
• The issue is whether the cost savings are
large enough to justify the necessary capital
expenditure.
 Cost-Cutting Proposals
• We are considering automating some part of an existing
production process. The necessary equipment costs
$80,000 to buy and install.
• The automation will save $22,000 per year (before taxes)
by reducing labor and material costs.
• For simplicity, assume that the equipment has a five-year
life and is depreciated to zero on a straight-line basis over
that period. It will actually be worth $20,000 in five
years.
• Should we automate? The tax rate is 34 percent, and the
discount rate is 10 percent.
 Cost-Cutting Proposals
• Step 1: Determine relevant cash flows
 Cost-Cutting Proposals
• Step 1: Determine relevant cash flows
• The initial cost is $80,000.
• The after tax salvage value is $20,000 X (1
− .34) = $13,200 because the book value will
be zero in five years
• There are no working capital consequences
 Cost-Cutting Proposals
• Step 2: Find OCF
 Cost-Cutting Proposals
• Step 2: Find OCF
• We save $22,000 before taxes every year.
• We have an additional depreciation deduction.
• In this case, the depreciation is $80,000/ 5 =
$16,000 per year.
 Cost-Cutting Proposals
• Step 3: Find NPV
 Setting the Bid Price
• The NPV approach can also be used when
submitting a competitive bid to win a job.
• Under such circumstances, the winner is
whoever submits the lowest bid.
 Setting the Bid Price
• Imagine we are in the business of buying stripped-
down truck platforms and then modifying them
to customer specifications for resale.
• A local distributor has requested bids for 5 specially
modified trucks each year for the next four years,
for a total of 20 trucks in all.
• We need to decide what price to bid per truck.
The goal of our analysis is to determine the lowest
price we can profitably charge.
 Setting the Bid Price
• We can buy the truck platforms for $10,000
each. The facilities we need can be leased for
$24,000 per year.
• The labor and material for the modification
cost about $4,000 per truck.
• Total cost per year will thus be $24,000 +5 X
(10,000 + 4,000) + $94,000.
 Setting the Bid Price
• We will need to invest $60,000 in new equipment.
This equipment will be depreciated straight-line to a
zero salvage value over the four years. It will be
worth about $5,000 at the end of that time.
• We will also need to invest $40,000 in raw
materials inventory and other working capital
items. The relevant tax rate is 39 percent.
• What price per truck should we bid if we require
a 20 percent return on our investment?
 Setting the Bid Price
• We have to spend $60,000 today for new
equipment. The after tax salvage value is
$5,000 X (1 − .39) = $3,050.
• Furthermore, we have to invest $40,000 today
in working capital. We will get this back in
four years.
Setting the Bid Price
 Setting the Bid Price
• The lowest possible price we can profitably
charge will result in a zero NPV at 20
percent.
• At that price, we earn exactly 20 percent on
our investment.
 Setting the Bid Price
• Step 1: Determine what the operating cash
flow must be for the NPV to equal zero.
• To do this, we calculate the present value of
the $43,050 non operating cash flow from the
last year and subtract it from the $100,000
initial investment
Setting the Bid Price
Setting the Bid Price
Setting the Bid Price
 Setting the Bid Price
• The final problem is to find out what sales
price results in an operating cash flow of
$30,609.
Setting the Bid Price
 Setting the Bid Price

• Sales per year must be $134,589. Because the contract

calls for five trucks per year, the sales price has to be
$134,589/5 = $26,918.
• If we round this up a bit, it looks as though we need to
bid about $27,000 per truck.
• At this price, were we to get the contract, our return
would be just over 20 percent.
Investments of Unequal Lives
• Firm must choose between two machines of
unequal lives.
• Both machines can do the same job, but they
have different operating costs and will last
for different time periods.
• A simple application of the NPV rule suggests
taking the machine whose costs have the
lower PV.
Investments of Unequal Lives
• This choice might be a mistake because the
lower-cost machine may need to be replaced
before the other one. (Any every day example
in mind ?)
Investments of Unequal Lives
Investments of Unequal Lives
Investments of Unequal Lives
Investments of Unequal Lives
• Equivalent Annual Cost for Machine A:
$321.05
• Equivalent Annual Cost for Machine B:
$289.28
• Machine B is the right choice
 Practice Questions
• Practice Baldwin Case Study