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chapter8

# chapter8 - 8-1 Chapter 8 Using Discounted Cash Flow...

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Semih Yildirim ADMS 3530 8 - 1 Chapter 8 Using Discounted Cash Flow Analysis Chapter Outline Discount Cash Flows, Not Profits Discount Incremental Cash Flows Discount Nominal Cash Flows by the Nominal Cost of Capital Separate Investment and Financing Decisions Calculating Cash Flow Business Taxes in Canada and the Capital Budgeting Decision Example: Blooper Industries

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Semih Yildirim ADMS 3530 8 - 2 Discount Cash Flows not Profits In Chapter 6 you learned to evaluate a project: Step 1: Forecast the projected cash flows. Step 2: Estimate the opportunity cost of capital. Step 3: Discount the cash flows at the opportunity cost of capital. Step 4: Calculate the NPV where NPV = PV of Cash flows – Initial Investment Decision: Go ahead with the project if NPV 0. In this chapter, you will learn how to prepare cash flow estimates for use in a NPV analysis. That is we will discount cash flows not accounting profits .
Semih Yildirim ADMS 3530 8 - 3 Discount Cash Flows not Profits Remember, forecasts of cash flows will not arrive on a silver platter, all ready to go into your analysis! You will have to deal with raw data supplied by consultants, production, marketing, etc. You will also have to adjust data prepared in accordance with accounting principals. Accounting numbers use historic costs and accounting income, not market values and CFs, which are necessary for a NPV analysis. Discounting accounting income, rather than cash flow, will lead to erroneous decisions. For example: A projects cost \$2,000 (C 0 ) and has an opportunity cost of capital of 10%. It has a 2 year life. It will produce cash revenues of \$1,500 and \$500. The project can be depreciated at \$1,000 per year. Compare the NPV using cash flow to the NPV using accounting income.

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Semih Yildirim ADMS 3530 8 - 4 t=0 t=1 t=2 Cost (C 0 ) (2,000) Cash Income 1,500 500 Cash Flow (2,000) 1,500 500 Cash Income - 1,500 500 Depreciation - (1,000) (1,000) Accounting Income - 500 (500) Discount Cash Flows Discount Cash Flows not Profits
Semih Yildirim ADMS 3530 8 - 5 Discount Cash Flows Discount Cash Flows not Profits Accounting NPV: + 500 + - 500 1.10 1.10 2 = \$41.32 - 2,000 + 1,500 + 500 1.10 1.10 2 = -\$223.14 ACCEPT THE PROJECT REJECT THE PROJECT NPV of Cash Flow:

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Semih Yildirim ADMS 3530 8 - 6 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 (\$1,500 + \$500 = \$2,000 or the cost). This means we are getting a zero return when we could be
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chapter8 - 8-1 Chapter 8 Using Discounted Cash Flow...

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