Discounted Cash Flow Analysis

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					   Capital Budgeting

Economic concepts and finance
    decision-making tools
          BUS 219
Building Blocks of Knowledge

                  Time value of money – a
                   dollar in the future is worth
                   less than a dollar in hand
                  Net present value
                   1. NPV = PV of cash flow
                      benefits– Investment cost
                   2. Accept project if NPV > $0
                  Financial Statements
                  Cash is king
    What is this slide show about?

   Ingtegrates topics
    from several
    chapters of
    Corporate Finance
    – NPV
    – Discounted cash-
      flow analysis
    – Project analysis
          Capital Budgeting

 Investment decisions involving capital
  assets (tangible property, including
  durable goods, equipment, buildings,
  installations, land)
 Capital refers to the fixed assets of an
  organization (factories, hospitals,
  schools, and their major equipment fit
  into this category),
Capital Budgeting (more)

 A budget is a plan which explains the
  projected cash flows during some future
 A capital budget is therefore an outline of
  planed expenditures on fixed assets, and
  capital budgeting is the whole process of
  analyzing projects and deciding whether
  they should be included in the capital
Capital Budgeting - Public Sector

 Capital budgeting is done in the public sector
  too, although it is not always referred to as
 Economic analysis and investment analysis
  are synonymous terms that one my hear.
 Benefit-cost analysis and cost-effectiveness
  analysis play an important role in the process
  of capital budgeting
Capital budgeting decisions
are among the most
important ones made by
managers and executives.

 Results of investments in schools and
  hospitals continue for many years.
 Once these decisions are made, the
  organization loses some of its flexibility.
 Once a major piece of equipment is
  purchased, the organization is “locked
  in” to using it for the long term.
Importance (more)
 Errors in the forecast need for big ticket
  assets can have serious consequences
 Imagine an office or hospital being built, or a
  school established, and then there is not
  enough demand to utilize the services.
 Conversely, what happens if not enough is
  spent. Inadequate capacity in a business,
  hospital or school can have disastrous
Importance (even more)
   Timing is anotther reason that good capital
    budgeting is so essential.
   Essential assets need to be ready to come “on-
    line” when needed. Early arrivals cause extra
    expenses that will strain resources.
   Funding of such major projects involves very
    substantial expenditures. Large amounts of
    money are not available instantaneously in any
    organization, be it a large corporation, school
    district or the federal government.
Capital budgeting has become more
effective, and more fun, during the past
 Used to be math and manpower intensive,
  because the underlying theory needs a lot of
 Nowadays, most modern organizations are
  able to use computers to transform data to
 Capital budgeting used to take man years of
  work, mostly in manual calculations. Now
  capital budgeting is done in hours with
“What was once a budget
exercise becomes an
analysis of policy” (Peter
Steps in the Capital Budgeting
1. Determine the economic life of the
  project or alternatives you are
2. Estimate their Incremental Cash Flows
3. Determine the discount rate.
4. Calculate Net Present Value
5. Apply the appropriate criterion to arrive
  at an initial preference
More Steps in the Capital
Budgeting Process
6. Do Sensitivity & Scenario Analysis
7. Interpret the results of the basic analysis
    and the sensitivity/scenario analysis, and
    make a decision.
8. If you decide to aquire the use of an
    asset, evaluate: lease versus buy
9. Check to make sure you can afford your
    decision by putting it in the organization’s
10. Implement & Verify your decision.
Capital Budgeting Decision
   Concepts you must
    understand to be able to
    – incremental cash flows
    – the time value of money and
    – sensitivity analysis
        Incremental Cash Flows
              Two Rules
   Annual cash flow, and not accounting
    profits or costs, are to be used.
    Depreciation and the need for Working
    Capital are causes of major differences
    between profits and cash flow
   Only Incremental cash flows are relevant
    for evaluating investment projects. Only
    those cash flows that would result directly
    from a decision to accept a project are
Working Capital

 The payroll needs to be paid before
  revenues from the days work are
 Working capital is the cash you need to
  pay expenses before the benefits are
Taxes and Depreciation

 Taxes are a fact of life, and need to be
  considered in all financial decisions
 Depreciation is an expense that is not a
  negative cash flow; to the contrary
  depreciation results in a tax shield (a
  positive cash flow) that offsets taxes to
  some extent
    Incremental Cash Flows Example
 a firm considering the establishment of a
  branch office in a newly developing section of
  a city
 Incremental cash flows will consist of the
  costs of investment and operating the new
  office, costs that it would not have been
  incurred unless the project was undertaken.
  It will also include the revenues derived from
  the business, benefits that would not have
  been realized otherwise.
Incremental Cash Flows
Three conceptual problems
   Sunk costs,

   Opportunity costs and

   Externalities.
Sunk Costs

 Sunk costs are cash outlays that have
  already been incurred and cannot be
  recovered regardless of any present or
  future decision.
 Sunk costs are not incremental costs
  and should not be included in capital
  budgeting analysis.
Sunk Cost Example

  The firm and its branch office decision.
 Suppose it hired a consulting firm two
  years ago to do a site analysis. The
  $75,000 they paid is irrelevant, a sunk
  cost, because it cannot be recovered no
  matter whether or not they decide to
  build their new branch office.
Easier said than done

  It may be psychologically impossible for
 policy makers to ignore sunk costs for
 future decisions, even though it is
 accepted practice in higher circles. There
 is a natural tendency to continue with a
 course of action, unable to see that it was
 incorrect, even when there is evidence to
 show the project is doomed to fail. The
 term used for this behavioral process is
 escalation of commitment
Opportunity costs

 Consider the firm with the branch office
 Suppose they own land upon which the
  branch could be built.
 Should they ignore the cost of the land
  because they will not have a cash outlay to
  acquire it?
 No, because if they don’t use the land they
  could sell it, for let us say $100,000.
An opportunity cost is a benefit
 Opportunity cost is the maximum worth
  of an asset among possible alternative
 Opportunity cost is thus a cash flow that
  could be generated from assets the
  organization already owns provided
  they are not used for the project in

 Externality is an economic term, which
  comes from the idea that we should
  account for the direct effects, whether
  positive or negative, on someone’s
  welfare that arise as a by-product of
  some other person’s or firm’s activity
 Synonyms are neighborhood,
  interactive or spillover effects
Externalities (more)

 Consider the firm’s present customers who
  might use the new branch office. Business
  they do at the branch will reduce business at
  the main office. That effect needs to be
  accounted for in the analysis.
 Branch office incremental revenues should be
  reduced by the amount of decreased
  revenues at the main office, say $25,000/yr.
    Summary - Economic Concepts
    for use in discounted cash flow
   Do use
    – Incremental Cash inflows
      and outflows
    – External benefits/costs
    – Opportunity costs             Do not include
                                     – Accounting profits
                                     – Sunk costs
Time Value of Money

 What do you do with future incremental
  cash flows of a project?
 Calculate their Net Present Value!
    – Start with displaying them on a time line
   Firm invests $500,000 in a new branch next
    year, estimates it would return a net* of
    $100,000 ($500,000 in revenues offset by
    $400,000 in expenses) annually beginning a
    year latter. Sunk costs are not included.
    $100 opportunity cost is added to the initial
    investment for a first year total cost of $600,
    000. $25,000/yr. external cost of the reduced
    revenues at the home office should be
    accounted for.
*i.e. the effects of taxes and depreciation are included
                   Time Line: Incremental Cash Flows for the New Branch Office Project
           Year     0         1         2          3          4          5          6          7          8          9
 Cash Flow          ($600k) 75k              75k        75k        75k        75k        75k        75k        75k        75k

                        Underlying Data & Calculations for the New Branch Office Project
Investment         $500k
Opportunity Cost 100k
External Cost                 25k       25k        25k        25k        25k        25k        25k        25k        25k
Operations Cost*              400k      400k       400k       400k       400l       400k       400k       400k       400k
Revenues                      500k      500k       500k       500k       500k       500k       500k       500k       500k
Net Cash In (out) (600k)          75k       75k        75k        75k        75k        75k        75k        75k        75k
*Includes effects of taxes and depreciation
The dilemma facing the firm
   Do you invest something now with a promise
    of a return in the future? It’s not a simple
    case of foregoing $600,000 and recovering
    $650,000($75,000 x 9) over the next 9 years.
    Dollars received in the future cannot be
    equated to dollars spent in the near term.
    Money in hand has more value than a like
    amount of money in the future because of the
    opportunity it represents. The challenge is
    how to account for this time value of money.
Calculating the Project’s NPV

 Determine the discount rate
 Calculate the present value of each
  year’s cash flow
 Sum PV of future cash flows, then
  subtract the investment to get NPV
Discount rates are estimates of an
organization’s cost of capital

 If you as an individual were going to
  invest in a project, the alternative use of
  your money would be the clue to your
  cost of capital.
 A firm’s cost of capital depends on
  where it would get the cash to fund the
Firm’s cost of capital

 If it borrowed it, the cost of capital would
  be the after tax interest rate it pays on a
  loan or the bonds it issues.
 If the business sold more stock to raise
  the money, the cost of capital would be
  the rate of return the stockholders
  expect to get.
Cost of capital

 If the project is funded with cash from the
  business’s accounts, then the cost of capital
  would be the estimated rate of return on
  alternative investments.
 Often, businesses get money from all three
  sources. When this is the case, they
  estimate their cost of capital by a weighted
  average calculation. (Chapter 12)
Riskier Projects > Higher
     Discount Rate
              Weighted average
               cost of capital is a
               good discount rate
               for average risk
              Higher risk projects
               should use a higher
               than average cost of
NPV of the Firm’s Project
   Year     0       1   2    3    4    5    6    7    8    9

   Net      $     75   75   75   75   75   75   75   75   75
   Cash     (600)
   Flow     K
   PV       1.000 .935 .873 .816 .763 .713 .666 .623 .582 .544
   PV  $     70         66   61   57   53   50   47   44   41
   @7% (600)
   NPV      $
Calculating NPV

 Can use the Formula
 Tables (as done on the previous slide)
 Calculator
 Spreadsheets make it really easy
Making an Initial Decision

   Follow a criterion, or decision rule.
    Which rule to follow depends upon the
    circumstances. If you are in business
    and your objective is to turn a profit and
    increase shareholder’s wealth, the rule
    is simple: you accept any project that
    has a positive net present value
Special Rule

  If projects are mutually exclusive, then
  you choose among them by picking the
  one with the highest positive net present
 Mutually exclusive projects are ones
  that would not be chosen together, like
  building a bridge and buying ferry boats
  to traverse the same route.
Sensitivity Analysis

 Nothing is certain in the future. Since
  that is where the consequences of
  capital budgeting decisions occur, we
  must challenge the assumptions
  underlying our calculations.
 We know estimates are wrong. Its a
  matter of how wrong they have to be to
  cause us to make a bad decision.

 Sensitivity analysis in general refers to a
  repetition of analysis using different
  values for uncertain factors.
 If a reasonable change in an assumed
  value results in a change in preference
  among choices, then the decision is
  said to be sensitive to that assumption
  or that variable
How to do “what if”

 In capital budgeting, sensitivity analysis
  measures the effect of changes to a
  particular variable, say annual operating
  cost, on a project’s present value
 All variables are fixed at their expected
  values, except one. That one variable is
  then changed, often by specified
  percentages, and the resulting effect on
  present value is noted
Sensitivity Analysis Routine

   Spreadsheets and contemporary PC
    technology make the performance of
    sensitivity analysis a piece of cake.
    Excel is ideally suited for sensitivity
    analysis. Once a model is created, it is
    very easy to change the values of
    variables and obtain new results.

   Identify those variables which potentially
    have the greatest impact on success or
   Helps policy makers focus attention on
    these variables that are probably most
   The sources of the estimates of these
    variables should be further scrutinized,
    and alternative sources sought.
Sensitivity Analysis

 Above all else, it serves as a risk
  assessment tool
 If a reasonable change in an estimate
  causes the outcome to go from a
  success to a failure, then the decision is
How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects of
  changes in single variables (sales, costs, etc.)
  on a project.
Scenario Analysis - Project analysis given a
  particular combination of assumptions.
   – Worst Case Scenario
   – Best Case Scenario
   – Most Likely Scenario
 Capital budget decisions are among the
  most important ones a firm can make
 Steps. For each project:
    1.  Estimate economic life
    2.  Estimate Incremental Cash Flows
    3.  Determine the discount rate
    4.  Calculate Net Present Value
    5.  Order preference of all projects based on NPV
    6.  Do Sensitivity & scenario analysis
    7.  Interpret the results of the basic analysis and the
        sensitivity/scenario analysis, and make a decision.
    8. Decide: lease or buy
    9. Plan to implement what you can afford
    10. Follow up, verify and adjust
Capital Budget Decision Process
                          Cost of

           Determine                       NPV
          Discount Rate

  Start                    cash-flow
                                                               Sensitivity &
          Cash Flows                   Lease or        yes           Do the
           (Income                                  End:
          Statement)                               decision