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# SEC06 - UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL...

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UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL LECTURE NOTES FNCE 601 FINANCIAL ANALYSIS Franklin Allen Fall 2003 QUARTER 1 - WEEK 4 Tu: 9/23/03 and Th: 9/25/03 Copyright 2003 by Franklin Allen

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FNCE 601 & Section 6 & Page 1 Section 6: Practical Aspects of the NPV Rule Read Chapter 6 BM Motivation We know how to calculate present values given cash flows but how do you actually evaluate projects? How do you use accounting data when applying the NPV rule? For example, how do you do problems like the following example? Example 1 The Pierpont Company is thinking of building a plant to make trumpets. The plant and equipment will cost \$1 million. It will last for five years and will have no salvage value at the end of that time. The costs of running the plant are expected to be \$100,000 per year. The revenues from selling the trumpets are expected to be \$375,000 per year. All cash flows occur at the end of the year. The firm uses straight line depreciation. Its corporate tax rate is 35 percent and the opportunity cost of capital for this project is 10 percent. The projected income statement for the project is as follows. Revenues \$375,000 Operating Expenses -\$100,000 Net Operating Income \$275,000 Depreciation -\$200,000 Taxable Income \$75,000 Taxes -\$26,250 Net Income \$48,750 Should the firm build the plant?
FNCE 601 - Section 6 - Page 2 Introduction How do we apply the NPV rule? Discount cash flows. This is all right as far as it goes, but so far we have not said exactly what we mean by cash flows--what should we include and what should we not include from accounting data? This is what we’re going to consider next. There are four general rules. Rule 1: Cash flow after taxes, not net income, is the proper basis for capital budgeting analysis. The points to remember are: (i) Always estimate cash flows on an after-corporate tax basis, since this is what shareholders are interested in. Hence if the corporate tax rate is denoted t c the effect of additional gross revenues R is (1-t c )R after tax and the effect of additional gross costs C is (1-t c )C after tax. (ii) You have to transform accounting data into cash flows. This is not always easy. For example, such things as depreciation are not cash flows although the tax savings due to the tax deductibility of depreciation are. Suppose the corporate tax rate is t c = 35%. If you have a \$100 depreciation deduction it reduces taxable income by \$100 and hence taxes by \$35. The value of a tax shield is t c x Depreciation. Note that it is equivalent to subtract out depreciation then subtract taxes and finally add back depreciation. This can be seen as follows. (1-t c )(Net operating income - Depreciation) + Depreciation = (1-t c )NOI - (1-t c )Depreciation + Depreciation = (1-t c )NOI + t c x Depreciation

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FNCE 601 - Section 6 - Page 3 (iii) Interest and dividends are not cash flows - they are taken account of by discounting. If they were subtracted out again there would be double counting.
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SEC06 - UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL...

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