1. Chapter 9 Learning Objectives
1. Identify the cash flows properly attributable to a proposed new project.
2. Calculate the cash flows of a project from standard financial statements.
3. Understand how the company’s tax bill is affected by depreciation and how this affects project value.
4. Understand how changes in working capital affect project cash flows.

2. Cash Flows
Chapter 8 introduced valuation techniques based on discounted cash flows.
This chapter develops criteria for properly identifying and calculating cash flows.
Chapter 9 Outline
Identifying Cash Flows
Discount Cash Flows, Not Profits
Discount Incremental Cash Flows
Discount Nominal Cash Flows by the Nominal Cost of Capitol
Separate Investment & Financing Decisions
Calculating Cash Flows
Example: Blooper Industries 2

3. Identifying Cash Flows: Cash Flow vs. Accounting Income
Discount actual cash flows, not necessarily net income.
Using accounting income, rather than cash flow, could lead to erroneous decisions. 4

4. NPV: Accounting Income
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 flows to the NPV using accounting income. 6

5. NPV: Cash Flows Which is correct? Example (ctd)
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 flows to the NPV using accounting income.
Which is correct? 8

6. 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
Remember Shutdown Cash Flows
Incremental Cash Flow – The extra cash flows produced by a project.
Incremental Cash Flow
Cash Flow with Project
Cash Flow without Project = - 9

7. Inflation and Discounting Cash Flows
Discounting Rule: Real cash flows must be discounted at a real discount rate, nominal cash flows at a nominal rate.
Inflation – rising price levels
Discounting Rule: Real cash flows must be discounted at a real discount rate, nominal cash flows at a nominal rate. 12

8. Inflation Example: Nominal Rates
You own a lease that will earn you $8,000 next year, increasing at 3% a year for 3 additional years (4 years total). If discount rates are 10% what is the present value of the lease? 15

9. Inflation Example: Real Rates
Example (ctd)
You own a lease that will earn you $8,000 next year, increasing at 3% a year for 3 additional years (4 years total). If discount rates are 10%, what is the present value of the lease? 16

10. Include all Indirect Effects
Indirect Effect Rule: You must include all indirect effects in your analysis.
Indirect Effect Rule: You must include all indirect effects 17

11. Sunk Cost Rule: Always ignore sunk costs.
– A cost that cannot be recovered
Sunk Cost Rule: Always ignore sunk costs.
Sunk Cost – A cost already paid that cannot be recovered
Sunk Cost Rule: Always ignore sunk costs. 17

12. Opportunity Costs
Opportunity Cost – Benefit or cash flow foregone as a result of an action.
Opportunity Cost Rule: Be sure to recognize the opportunity cost (that which is foregone).
Opportunity Cost – Benefit or cash flow foregone as a result of an action.
OPPORTUNITY COST RULE: Be sure to recognize the opportunity cost (that which is foregone) 17

13. Investments in Working Capital
Working Capital Rule: Investments in working capital, just like investments in plant and equipment, result in cash outflows.
Net Working Capital – Current assets minus current liabilities
Working Capital Rule: Investments in working capital, just like investments in plant and equipment, result in cash outflows.
Common ways working capital is overlooked:
1. Forgetting about working capital entirely.
2. Forgetting that working capital may change during the life of the project.
3. Forgetting that working capital is recovered at the end of the project. 17

14. Additional Considerations
Remember Terminal Cash Flows
Beware of Allocated Overhead Costs
Separation of Investment & Financing Decisions 17

15. Final Thought: Incremental Cash Flows
Ask the following 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. 11

16. Calculating Cash Flows
Cash flows are made up of three separate parts.
Total cash flow =
+ cash flows from capital investments
+ cash flows from changes in working capital + operating cash flows

17. Calculating Cash Flows
Capital Investments
Changes in Working Capital
Operating Cash Flows  Operating cash flow = Revenue – Costs – Taxes

18. Cash Flow from Operations: Three Methods of Calculation
Method 1: Dollars in Minus Dollars Out
Method 2: Adjusted Accounting Profits
Method 3: Tax Shields
Depreciation Tax Shield – Reduction in taxes attributable to depreciation. 11

19. Calculating Cash Flow: Example
Year 0
Year 1
Year 2
Year 3
Year 4
Fixed Assets
Purchase of Factory (sale in 4 years)
-$100,000 $
$ 50,000
Total Cash Flow from Fixed Assets
Working Capital
CF from Inventory (- buildup,+ sell off)
-$ 20,000
-$ 10,000
$ 10,000
$ 20,000
CF from Accounts Receivable
-$ 35,000
-$ 25,000
$ 30,000
Total Cash Flow from Working Capital
-$ 55,000
$ 40,000
Operations
Revenues
$120,000
$125,000
$150,000
Expenses
$ 60,000
$ 61,250
$ 70,000
Depreciation
$ 12,500
Pre-Tax Profits
$ 47,500
$ 51,250
$ 67,500
After-Tax Profits (tax rate = 35%)
$ 30,875
$ 33,313
$ 43,875
Total Cash Flow from Operations
$ 43,375
$ 45,813
$ 56,375
Total Cash Flow
-$11,625
$10,813
$ 96,375
$106,375 11