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Chapter 8 - Chapter 8 Discounted Cash Flow Analysis 1 Plan...

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1 Chapter 8 Discounted Cash Flow Analysis
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2 Plan of the lecture Discounting cash flows, not profits Incremental cash flows Calculating cash flow Business taxes in Canada Example: Joy Corp.
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3 Calculating NPV There are four steps involved in computing the NPV of a project Step 1 : forecast the amount and timing of a project’s future cash flows Step 2 : estimate the appropriate opportunity cost of capital Step 3 : discount all the future cash flows at the opportunity cost of capital Step 4 : subtract the initial investment C from the sum of the PV of cash flows to get the NPV
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4 Calculating NPV In Chapter 7 we have taken as given the future cash flows of a project In this chapter and Chapter 9 that follows, we will learn more about step 1 : how to estimate a project’s future cash flows?
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5 Discount cash flows, not profits In finance we focus on cash flows , rather than accounting profits ! Discounting profits instead of cash flows may lead to wrong decisions See the example on the next slides …
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6 Discount cash flows, not profits Example of discounting cash flows: A project costs $3,000 ( C 0 ) and has an opportunity cost of capital of 7%. It has a life of 2 years It will produce cash revenues of $2,000 and $1,000 in year 1 and year 2, respectively The project can be depreciated at $1,500 per year Compare the NPV using cash flow to the NPV using accounting income
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7 t=0 t=1 t=2 Cost (C 0 ) (3,000) Cash income 2,000 1,000 Cash flow (3,000) 2,000 1,000 Cash income - 2,000 1,000 Depreciation - (1,500) (1,500) Accounting income - 500 (500) Discount cash flows, not profits
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8 Discount cash flows, not profits Accounting NPV : + 500 + - 500 1.07 (1.07) 2 = $30.57 = $2,742.60 ACCEPT THE PROJECT REJECT THE PROJECT NPV of cash flow : 2,000 + 1,000 1.07 (1.07) 2 $2,742.60 - $3,000 = -$257.40
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9 Discount cash flows, not profits Discounting the accounting income gives an entirely different result from discounting the cash flows! The accounting NPV says to accept the project However, this answer makes no sense: The project is obviously a loser , since we only get our money back ($2,000 + $1,000 = $3,000 or the cost) The IRR of the project is zero ! At the same time we could be getting 7% in the market!
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10 Discount cash flows, not profits The NPV of the cash flows gives the right answer: This project is undesirable and should be rejected! Remember: Projects are attractive because of the cash flows they generate Therefore, the focus of investment decision must be cash flows and not profits
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11 Incremental cash flows Discount incremental cash flows NOT every cash flow is relevant for analyzing a project. ONLY the extra cash flows (revenues and costs) produced by the project are relevant
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12 Incremental cash flows Look for incremental benefits A project’s NPV depends on the extra cash flows it produces You should: 1. Calculate the firm’s cash flows if it goes ahead with the project 2. Calculate the cash flows if the firm doesn’t go ahead with the project 3. Take the difference , which gives you the extra , or incremental , cash flow of the project
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