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USING DISCOUNTED CASH-FLOW ANALYSIS TO MAKE INVESTMENT DECISIONS

Think of the problems that General Motors faces when considering whether to introduce a new model. How much will we need to invest in new plant and equipment? What will it cost to market and promote the new car? How soon can we get the car into production? What is the projected production cost? What do we need in the way of inventories of raw materials and finished cars? How many cars can we expect to sell each year and at what price? What credit arrangements will we need to give our dealers? How long will the model stay in production?

What happens at the end of that time? Can we use the plant and equipment elsewhere in the company? All of these issues affect the level and timing of project cash flows. In this material we continue our analysis of the capital budgeting decision by turning our focus to how the financial manager should prepare cash-flow estimates for use in net present value analysis.

Earlier we used the net present value rule to make a simple capital budgeting decision. You tackled the problem in four steps:

Step 1: Forecast the project cash flows.

Step 2: Estimate the opportunity cost of capital that is, the rate of return that your shareholders could expect to earn if they invested their money in the capital market.

Step 3: Use the opportunity cost of capital to discount the future cash flows. The project s present value (PV) is equal to the sum of the discounted future cash flows.

Step 4: Net present value (NPV) measures whether the project is worth more than it costs. To calculate NPV you need to subtract the required investment from the present value of the future payoffs:

NPV = PV required investment

You should go ahead with the project if it has a positive NPV.

We now need to consider how to apply the net present value rule to practical investment problems. The first step is to decide what to discount. We know the answer in principle: discount cash flows. This is why capital budgeting is often referred to as discounted cash flow, or DCF, analysis. But useful forecasts of cash flows do not arrive on a silver platter. Often the financial manager has to make do with raw data supplied by specialists in product design, production, marketing, and so on, and must adjust such data before they are useful. In addition, most financial forecasts are prepared in accordance with accounting principles that do not necessarily recognize cash flows when they occur. These data must also be adjusted.

We start with a discussion of the principles governing the cash flows that are relevant for discounting. We then present an example designed to show how standard accounting information can be used to compute those cash flows and why cash flows and accounting income usually differ. The example will lead us to various further points, including the links between depreciation and taxes and the importance of tracking investments in working capital.

After studying this material you should be able to

_ Identify the cash flows properly attributable to a proposed new project.

_ Calculate the cash flows of a project from standard financial statements.

_ Understand how the company s tax bill is affected by depreciation and how this affects project value.

_ Understand how changes in working capital affect project cash flows.