Cashflows_and_Advanced_DCF

Considerations in Net Present Value Analysis
Now that we have established the superiority of NPV lets revisit the steps involved in the Capital Budgeting Process.
• First - Estimate cash flows in the project.
• Second - Determine an opportunity cost of capital.
• Third - Apply NPV
• Fourth - Determine the selected alternative and implement.
• We will now take a look at the first step

Discounted Cash Flow Issues for NPV Analysis
1. Only cash flow is relevant, not accounting profits.
2. Only incremental cash flow matters.
3. Recognize all cash flow effects.
4. Recognize project interactions.
5. Be consistent in treatment of inflation.
6. Separate Investment and Financing Decisions.

Calculating Incremental Earnings
• The first step in evaluating a project is to calculate the incremental earnings generated by the project.
(Incremental Revenue – Incremental Cost – Depreciation)x(1-Tax Rate) = Incremental Earnings
• It is important to identify revenues and costs that are generated only because of the project.
• The Marginal Tax Rate is used because it captures the incremental effect of the project.

Pro-Forma Financial Statements
• Pro-Forma Statement: financials under a set of hypothetical assumptions
Revenues
- COGS (typically Variable Costs)
Incremental Gross Profit(Margin)
- Incremental Fixed Costs
- Depreciation
Earnings Before Interest and Taxes (EBIT)
- Tax @ Marginal Rate
Net Operating Profit after Tax (NOPAT)
NOTE: NOPAT excludes Interest

Other Issues
• Interest Expense
• Not included in capital budgeting because we consider the Financing Decision independently.
• Depreciation Expense
• These expenses are non-cash so they must be considered in cash flow estimates.
• Investment in Net Working Capital
• Income statement does not reflect changes in NWC so they must be considered in total cash flow estimates.
• Taxes and Negative EBIT:
• Creates tax savings that must be considered in cash flow estimates.

Taxes
• Taxes are critical financial decision making, every dollar paid in taxes enriches the government instead of the shareholders.
• Corporate Taxes - Paid by the corporation out of profits before shareholders are paid.
• Personal Taxes - Paid by the individuals from earned income and earnings from capital assets held as investments.
• System is progressive - Tax rate generally increases with income.
• Marginal Tax Rate - Tax Rate on next dollar of income.
• Average Tax Rate - Taxes paid/Pretax income

Marginal vs. Average Corporate Tax Rates
Taxable Income, Marginal Tax Rates, Cumulative Tax Liability, Average Rates
$0 - 50,000 15% $7,500 15.00%
50,001 - 75,000 25% 13,750 18.33%
75,001 - 100,000 34% 22,250 22.25%
100,001 - 335,000 39% 113,900 34.00%
335,001 - 10 mil 34% 3.4 mil 34.00%
10 mil - 15 mil 35% 5,150,000 34.33%
15 mil - 18.33 mil 38% 6,416,667 35.00%
18.33 mil + 35% N/A 35.00%
Notice that, while marginal rates fluctuate and rise as high as 39%, average rates increase steadily with taxable income, until the 35% level is reached

Only Incremental Cash Flows Matter
Definition of Incremental Cash Flow: CF with the Project – CF without the Project
• Include All Incidental or Indirect Effects
• Will project help or hurt existing projects
• Forget Sunk Costs
• Earlier decisions can’t be reversed today
• Include Opportunity Costs
• Value alternative uses of existing assets (market
value)

Only Incremental Cash Flows Matter
• Asset Sales
• Often projects include the disposition of equipment or buildings and the after tax cash proceeds must be included in the Total Cash Flow.
• Beware of Allocated Overhead
• Is overhead allocated truly incremental?

Depreciation Methods
• Depreciation is a non-cash expense and must be added back to cash flows.
• Normal practice is to allow only ½ of the first year of depreciation in the year the asset is acquired.
• Accelerated depreciation methods (e.g. MACRS) reduce net income through the earlier recognition of expenses than expense recognition under straight line depreciation.
• Cash flows actually increase because the tax reduction from depreciation (depreciation tax shield) is realized earlier.

Considerations in NPV Analysis Project Interactions
• Cannibalization
• New product will decrease sales of existing products.
• Incremental Benefits
• New product will increase sales of related accessories.

Impact of Inflation on NPV
• Most discount rates or Opportunity Cost of Capital estimates are nominal rates.
• Mixing Nominal Rates with Real Cash Flows gives incorrect values.
• Discount Nominal Cash Flows & Nominal Cost of Capital
• Remember Inflation when developing cash flow forecasts.
• Future prices and costs will probably be higher.
• Make sure fixed prices are considered.
• such as long term labor or supplier contracts

Considerations in Net Present Value Analysis
Separate Investment & Financing Decision
• The NPV of a project is independent of its Financing.
• Separate the Investment and Financing Decisions
• Do not include interest or principal payments
• Financial managers will have numerous financing alternatives based on the overall needs with prices set by the overall risk of the firm.

How Do We Know the NPV is Accurate
• Capital Budgeting Problems
• Consistent forecasts
• Conflict of interest
• Forecast bias
• Selection criteria (NPV and others)

• One Approach is Capital Rationing
• Additional Approaches
• Sensitivity Analysis
• Scenario Analysis
• Simulation Analysis
• Breakeven Analysis

Sensitivity Analysis
• Process - Test various individual assumptions to see the result on NPV.
• Various Cashflow assumptions are used.
• Scenarios are developed and NPVs compared:
• Optimistic
• Expected
• Pessimistic
Issues
• When various OCC are used, it is difficult to interpret the result.
• Limit to the amount of sensitivity analysis that can be meaningfully used.
Benefit
• Identifies critical assumptions.

Scenario Analysis
• Process – Test particular combinations of assumptions.
• Measure the change in NPV given an entirely new set of interrelated assumptions based on some alternative business environment.
• Example – A major competitor may react in differently to your project efforts and your assumptions change with their reaction.
• Lower their price
• Increase their marketing efforts
• Withdraw from the market
Benefit
• Scenario analysis is appropriate when assumptions are interrelated.

Simulation Analysis
• Process - Estimate of the probabilities of different possible outcomes.
• Expanded version of Scenario Analysis using statistical tools to test multiple scenarios to look at the distribution of possible outcomes.
• Method is highly quantitative and often involves hundreds of scenarios.
Issues
• Requires definition of probability distributions of inputs.
• Requires a model that defines the interaction of the various assumptions.
Benefit
• Identifies risk that is not apparent using traditional Scenario Analysis

Break-Even Analysis
• Analysis of the level of sales (or other variable) at which the company “breaks even.”
• Accounting Break-Even focuses on the point where Net Income becomes positive.
• Economic Break-Even focuses on the the point where NPV is greater than zero.

Flexibility & Real Options
Decision Trees - Diagram of sequential decisions and possible outcomes.
• Decision trees help companies determine their Options by showing the various choices and
outcomes.
• The Option to avoid a loss or produce extra profit has value.
• The ability to create an Option thus has value that can be bought or sold.

Common Real Options
Timing Option (Option to Delay)
The option to delay commitment (the option to time the investment) is almost always present.
A company would only choose to delay if doing so would increase the NPV of the project by more than the cost of capital over the time of delay.
Abandonment Option
An abandonment option is the option to walk away. Abandonment options can add value to a project because a firm can drop a project if it turns out to be unsuccessful.

Common Real Options
Option to Expand
The option to expand, is the option to start with limited production and expand only if a product is successful.
A company could, instead, test market the product in limited release before committing fully to it. It is possible that by reducing its upfront commitment, and only choosing to expand if a product is successful, that an increase the NPV of the product could result.

Some Notes of Caution in Real World Complications
• Sometimes Financing and Investment are linked.
• Assumptions and forecasts can be inconsistent.
• Conflicts of interest can emerge
• Forecasts can be biased
• “If it is so good why hasn’t someone else done it?”
• Competitive advantages
• Even with the complications NPV is worth the trouble.
• Objective Data Oriented
• Development of Assumptions and Forecasts requires a disciplined look at projects.
• Consistent with Increasing Shareholder Wealth