Chapter 9: Using Discounted cashflow analysis to make investment decisions

Question 1

How should the cash flows of a proposed new project be calculated? (LO9-1)

Answer 1

Here is a checklist to bear in mind when forecasting a project’s cash flows:
∙ Discount cash flows, not profits.
∙ Estimate the project’s incremental cash flows—that is, the difference between the cash flows with the project and those without the project.
∙ Include all indirect effects of the project, such as its impact on the sales of the firm’s other products.
∙ Forget sunk costs.
∙ Include opportunity costs, such as the value of land that you could otherwise sell.
∙ Beware of allocated overhead charges for heat, light, and so on. These may not reflect the incremental effects of the project on these costs.
∙ Remember the investment in working capital. As sales increase, the firm may need to make additional investments in working capital, and as the project finally comes to an end, it will recover these investments.
∙ Treat inflation consistently. If cash flows are forecast in nominal terms (including the effects of future inflation), use a nominal discount rate. Discount real cash flows at a real rate.
∙ Do not include debt interest or the cost of repaying a loan. When calculating NPV, assume that the project is financed entirely by the shareholders and that they receive all the cash flows. This separates the investment decision from the financing decision.

Question 2

How can the cash flows of a project be computed from standard financial statements? (LO9-2)

Answer 2

Project cash flow does not equal profit. You must allow for noncash expenses such as depreciation as well as changes in working capital.

Question 3

How is the company’s tax bill affected by depreciation, and how does this affect project value? (LO9-3)

Answer 3

Depreciation is not a cash flow. However, because depreciation reduces taxable income, it reduces taxes. This tax reduction is called the depreciation tax shield. Many countries require firms to deduct an equal amount of depreciation each year. Others allow firms to write off a larger proportion of the investment in the early years. Since 2018, the U.S. has adopted the ultimate in accelerated depreciation by allowing companies to write off the entire amount of the investment immediately.

Question 4

How do changes in working capital affect project cash flows? (LO9-4)

Answer 4

Increases in net working capital such as accounts receivable or inventory are investments
and therefore use cash—that is, they reduce the net cash flow provided by the project that period. When working capital is run down, cash is freed up, so cash flow increases.