Cash Flows

ADVANCED CORPORATE
FINANCE
Instructor:
Kumail Rizvi PhD, CFA, FRM
Kumail Rizvi, PhD, CFA, FRM
QUICK REFRESHER
NET PRESENT VALUE

01/10/2014
The difference between the market value of a project

and its cost
Kumail Rizvi PhD,CFA, FRM
CFt
NPV = CF0 t 1
t
(1 r )
n
Computation
The first step is to estimate the expected future
cash flows.
The second step is to estimate the required return
for projects of this risk level.
The third step is to find the present value of the
cash flows and subtract the initial investment.
3
NPV DECISION RULE
If the NPV is positive, accept the project
01/10/2014
A positive NPV means that the project is

expected to add value to the firm and will
therefore increase the wealth of the owners.
Since our goal is to increase owner wealth, NPV
is a direct measure of how well this project will
meet our goal.
4
COMPUTING NPV FOR THE PROJECT
NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3

165,000 = 12,627.42
Using the calculator:
Using the formulas:
01/10/2014
CF0 = -165,000; C01 = 63,120; F01 = 1; C02 =

70,800; F02 = 1; C03 = 91,080; F03 = 1; NPV; I =
12; CPT NPV = 12,627.41
Do we accept or reject the project?

5
DECISION CRITERIA TEST - NPV
Does the NPV rule account for the time value of

money?
Does the NPV rule account for the risk of the cash
flows?
Does the NPV rule provide an indication about the
increase in value?
Should we consider the NPV rule for our primary
decision rule?
01/10/2014
CALCULATING NPVS WITH A

SPREADSHEET
Spreadsheets are an excellent way to compute NPVs,

especially when you have to compute the cash flows as
well.
Using the NPV function
The first component is the required return entered as a
decimal
The second component is the range of cash flows
beginning with year 1
Subtract the initial investment after computing the
NPV
01/10/2014
INTERNAL RATE OF RETURN

01/10/2014
This is the most important alternative to NPV

It is often used in practice and is intuitively
appealing
It is based entirely on the estimated cash flows
and is independent of interest rates found
elsewhere
IRR DEFINITION AND DECISION RULE
Definition: IRR is the return that makes the NPV = 0

Decision Rule: Accept the project if the IRR is greater
than the required return
01/10/2014
COMPUTING IRR FOR THE PROJECT
Calculator
Enter the cash flows as you did with NPV
Press IRR and then CPT
IRR = 16.13% > 12% required return
If you do not have a financial calculator, then this

becomes a trial and error process
01/10/2014
Do we accept or reject the project?

10
NPV PROFILE FOR THE PROJECT

70,000
IRR = 16.13%
60,000
50,000
NPV
40,000
30,000
20,000
10,000
0
-10,000 0
0.02 0.04 0.06 0.08
0.1
0.12 0.14 0.16 0.18
-20,000
Discount Rate
0.2
0.22
DECISION CRITERIA TEST - IRR
Does the IRR rule account for the time value of

money?
Does the IRR rule account for the risk of the cash
flows?
Does the IRR rule provide an indication about the
increase in value?
Should we consider the IRR rule for our primary
decision criteria?
01/10/2014
12
CALCULATING IRRS WITH A

SPREADSHEET
You start with the cash flows the same as you did for the
NPV
You use the IRR function
You first enter your range of cash flows, beginning with
the initial cash flow
You can enter a guess, but it is not necessary
The default format is a whole percent you will
normally want to increase the decimal places to at least
two
01/10/2014
13
NPV VS. IRR
Initial investments are substantially different

Timing of cash flows is substantially different
Pitfall 1: Non-conventional cash flows cash flow

signs change more than once
Pitfall 2: Mutually exclusive projects
01/10/2014
NPV and IRR will generally give us the same

decision
Exceptions
Pitfall 3: Term structure assumption
14
INTERNAL RATE OF RETURN

01/10/2014
Term Structure Assumption

We assume that discount rates are stable during
the term of the project.
This assumption implies that all funds are
reinvested at the IRR.
This is a false assumption.
15
IRR AND NON-CONVENTIONAL CASH

FLOWS
When the cash flows change sign more than once, there is
more than one IRR
When you solve for IRR you are solving for the root of an
equation and when you cross the x-axis more than once,
there will be more than one return that solves the
equation
If you have more than one IRR, which one do you use to
make your decision?
01/10/2014
16
IRR AND NON-CONVENTIONAL CASH

FLOWS
01/10/2014
Example:
Suppose an investment will cost $90,000 initially and will
generate the following cash flows:
Year 1: 132,000
Year 2: 100,000
Year 3: -150,000
The required return is 15%.
Should we accept or reject the project?
17
NPV PROFILE
IRR = 10.11% and 42.66%
$4,000.00
$2,000.00
NPV
$0.00
($2,000.00)
0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45 0.5 0.55
($4,000.00)
($6,000.00)
($8,000.00)
($10,000.00)
Discount Rate
SUMMARY OF DECISION RULES

01/10/2014
The NPV is positive at a required return of 15%,

so you should Accept
If you use the financial calculator, you would get
an IRR of 10.11% which would tell you to Reject
You need to recognize that there are nonconventional cash flows and look at the NPV
profile
19
IRR AND MUTUALLY EXCLUSIVE

PROJECTS
Mutually exclusive projects

If you choose one, you cant choose the other
Example: You can choose to attend graduate school at
either Harvard or Stanford, but not both
Intuitively you would use the following decision rules:
NPV choose the project with the higher NPV
IRR choose the project with the higher IRR
01/10/2014
20
IRR AND MUTUALLY EXCLUSIVE

PROJECTS
Period Project Project

A
B
0
-500
-400
1
325
325
325
200
IRR
19.43
%
64.05
22.17
%
60.74
NPV
The required return

for both projects is
10%.
Which project should

you accept and why?
NPV PROFILES
$160.00
IRR for A = 19.43%
$140.00
IRR for B = 22.17%
$120.00
Crossover Point = 11.8%
NPV
$100.00
$80.00
A
B
$60.00
$40.00
$20.00
$0.00
($20.00) 0
0.05
0.1
0.15
($40.00)
Discount Rate
0.2
0.25
0.3
FINDING CROSSOVER RATE
Period Project
A
0
-400
1
250
2
280
Project
B
500
320
340
Crossover rate by definition is the discount rate

that makes the NPVs of two projects equal or the
difference in their NPVs is zero.
01/10/2014
23
CONFLICTS BETWEEN NPV AND IRR
NPV directly measures the increase in value to the

firm
Whenever there is a conflict between NPV and
another decision rule, you should always use NPV
IRR is unreliable in the following situations
Non-conventional cash flows
Mutually exclusive projects
01/10/2014
24
HOW TO ESTIMATE CASH FLOWS
KEY CONCEPTS AND SKILLS

Understand how to determine the relevant cash
flows for various types of proposed investments
Be able to compute depreciation expense for tax
purposes
Understand the method for computing operating
cash flow
RELEVANT CASH FLOWS
The cash flows that should be included in a capital

budgeting analysis are those that will only occur if
the project is accepted
These cash flows are called incremental cash flows
The stand-alone principle allows us to analyze each
project in isolation from the firm simply by focusing
on incremental cash flows
ASKING THE RIGHT QUESTION
You should always ask yourself Will this cash flow

occur ONLY if we accept the project?
If the answer is yes, it should be included in the

analysis because it is incremental
If the answer is no, it should not be included in
the analysis because it will occur anyway
If the answer is part of it, then we should
include the part that occurs because of the project
COMMON TYPES OF CASH FLOWS

Sunk costs costs that have accrued in the past
Opportunity costs costs of lost options
Side effects
Positive side effects benefits to other projects
Negative side effects costs to other projects
Changes in net working capital
Financing costs
Taxes
RELEVANT CASH FLOWS:

MAJOR CASH FLOW COMPONENTS
FINDING THE INITIAL INVESTMENT

Initial Investment
Where
NWC = Current Assets Current Liabilities
= Installed cost of new asset Change in Net

working Capital
CHANGE IN NET WORKING CAPITAL
FINDING THE OPERATING CASH INFLOWS
Operating CF = Net income + depreciation

when there is no interest expense
PROCEED FROM SALE OF ASSET

(CONT.)
Book Value = $100,000 - $52,000 = $48,000
Hudson Industries, a small electronics company, 2 years ago

acquired a machine tool with an installed cost of $100,000.
The asset was being depreciated under MACRS using a 5year recovery period. Thus 52% of the cost (20% + 32%)
would represent accumulated depreciation at the end of
year two.

(CONT.)
Sale of the Asset for More Than Its Purchase Price

If Hudson sells the old asset for $110,000, it realizes a gain of

$62,000 ($110,000 - $48,000).
Technically, the difference
between the cost and book value ($52,000) is called recaptured
depreciation and the difference between the sales price and
purchase price ($10,000) is called a capital gain. Under
current corporate tax laws, the firm must pay taxes on both the
gain and recaptured depreciation at its marginal tax rate.

(CONT.)
Sale of the Asset for More Than Its Book Value but
Less than Its Purchase Price
If Hudson sells the old asset for $70,000, it realizes

a gain in the form of recaptured depreciation of
$22,000 ($70,000$48,000) which is taxed at the
firms marginal tax rate.

(CONT.)
Sale of the Asset for Its Book Value

If Hudson sells the old asset for its book value of

$48,000, there is no gain or loss and therefore no
tax implications from the sale.

(CONT.)
Sale of the Asset for Less Than Its Book Value

If Hudson sells the old asset for $30,000 which is less

than its book value of $48,000, it experiences a loss of
$18,000 ($48,000 - $30,000). If this is a depreciable
asset used in the business, the loss may be used to
offset ordinary operating income.
If it is not
depreciable or is not used in the business, the loss can
only be used to offset capital gains.

(CONT.)
Expansion Project
CASH FLOW PROJECTION
EXPANSION PROJECT
An expansion project includes investment outlay of

$200,000 for fixed capital items. This outlay includes
$25,000 for non-depreciable land and $175,000 for
equipment that will be depreciated straight line to
zero over five years. The investment required in net
working capital is $30,000 at time 0. Each year sales
will be $220,000 and cash expenses would be $90,000.
The tax rate is 40%. At the end of year 5, company
will sell the fixed capital assets. In this case, fixed
assets (including land) will be sold at $50,000.
Additionally, investment in net working capital will
be recovered. The tax rate is 40%
Should company accept this project?
EXPANSION PROJECT
Replacement Decision
COMPREHENSIVE PROJECT
ANALYSIS
RELEVANT CASH FLOWS: EXPANSION

VERSUS REPLACEMENT CASH FLOWS
FINDING OPERATING CASH FLOWS
OCF = (Sales Cost Depreciation)(1 - T) + D

Where
Incremental Sales
= Sales from new asset Sales from old asset
Incremental Cash Expenses
= Exp. from new asset Exp. from old asset
Incremental Depreciation
= Dep. of new asset Dep. of old asset
FINDING THE TERMINAL CASH FLOW
POWELL CORPORATION (REPLACEMENT)
Powell Corporation, a large diversified manufacturer of aircraft

components, is trying to determine the initial investment required
to replace an old machine with a new, more sophisticated model.
The machines purchase price is $380,000 and an additional
$20,000 will be necessary to install it. It will be depreciated under
MACRS using a 5-year recovery period. The firm has found a
buyer willing to pay $280,000 for the present machine and remove
it at the buyers expense. This machine was bought 3 years back for
$240,000 and was depreciated under MACRS using a 5-year
recovery period. The firm expects that a $35,000 increase in
current assets and an $18,000 increase in current liabilities
will accompany the replacement. Both ordinary income and capital
gains are taxed at 40%.

(CONT.)
Outflow from the purchase of proposed machine is reduced

by the benefits received from selling old machine at time 0
Powell Corporations estimates of its revenues and

expenses (excluding depreciation and interest), with and
without the new machine described in the preceding
example, are given in Table 8.5. Note that both the
expected usable life of the proposed machine and the
remaining usable life of the existing machine are 5 years
(old machine was purchased three years back). The
amount to be depreciated with the proposed machine is
calculated by summing the purchase price of $380,000
and the installation costs of $20,000.

(CONT.)

(CONT.)
FINDING THE OPERATING CASH INFLOWS (CONT.)

(CONT.)

(CONT.)
Continuing with the Powell Corporation example,

assume that the firm expects to be able to liquidate the
new machine at the end of its 5-year useable life to net
$50,000 after paying removal and cleanup costs. The old
machine can be liquidated at the end of the 5 years to net
$10,000. The firm expects to recover its $17,000 net
working capital investment upon termination of the
project. Again, the tax rate is 40%.

(CONT.)
Inflow from the sale of proposed machine is reduced by the

benefits forgone by selling old machine at time 0
SUMMARIZING THE RELEVANT CASH FLOWS
Due on Tuesday (25th September)
ASSIGNMENT
REPLACEMENT PROJECT

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ADVANCED CORPORATE

Kumail Rizvi, PhD, CFA, FRM

NET PRESENT VALUE

The difference between the market value of a project

Kumail Rizvi PhD,CFA, FRM

NPV DECISION RULE

If the NPV is positive, accept the project

Kumail Rizvi PhD,CFA, FRM

A positive NPV means that the project is

COMPUTING NPV FOR THE PROJECT

NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3

Kumail Rizvi PhD,CFA, FRM

Using the formulas:

CF0 = -165,000; C01 = 63,120; F01 = 1; C02 =

Do we accept or reject the project?

DECISION CRITERIA TEST - NPV

Does the NPV rule account for the time value of

Kumail Rizvi PhD,CFA, FRM

CALCULATING NPVS WITH A

Kumail Rizvi PhD,CFA, FRM

Spreadsheets are an excellent way to compute NPVs,

INTERNAL RATE OF RETURN

This is the most important alternative to NPV

Kumail Rizvi PhD,CFA, FRM

IRR DEFINITION AND DECISION RULE

Kumail Rizvi PhD,CFA, FRM

Definition: IRR is the return that makes the NPV = 0

COMPUTING IRR FOR THE PROJECT

Kumail Rizvi PhD,CFA, FRM

If you do not have a financial calculator, then this

Do we accept or reject the project?

NPV PROFILE FOR THE PROJECT

0.02 0.04 0.06 0.08

0.12 0.14 0.16 0.18

DECISION CRITERIA TEST - IRR

Kumail Rizvi PhD,CFA, FRM

Does the IRR rule account for the time value of

CALCULATING IRRS WITH A

Kumail Rizvi PhD,CFA, FRM

NPV VS. IRR

Initial investments are substantially different

Kumail Rizvi PhD,CFA, FRM

Pitfall 1: Non-conventional cash flows cash flow

NPV and IRR will generally give us the same

Pitfall 3: Term structure assumption

INTERNAL RATE OF RETURN

Term Structure Assumption

IRR AND NON-CONVENTIONAL CASH

Kumail Rizvi PhD,CFA, FRM

IRR AND NON-CONVENTIONAL CASH

SUMMARY OF DECISION RULES

The NPV is positive at a required return of 15%,

IRR AND MUTUALLY EXCLUSIVE

Kumail Rizvi PhD,CFA, FRM

Mutually exclusive projects

IRR AND MUTUALLY EXCLUSIVE

Period Project Project

The required return

Which project should

IRR for A = 19.43%

IRR for B = 22.17%

Crossover Point = 11.8%

FINDING CROSSOVER RATE

Kumail Rizvi PhD,CFA, FRM