Investment Criteria and

Free Cash Flows in

Finance

Capital Budgeting Decisions

Today’s agenda

⚫ Net Present Value (revisit)

⚫ Other two investment rules
⚫ Free cash flows calculation
⚫ A specific example
Net Present Value rule (NPV)

⚫ NPV is the present value of a project

minus its cost
⚫ If NPV is greater than zero, the firm
should go ahead to invest; otherwise
forget about this project
⚫ A hidden assumption: there is no budget
constraint or money constraint.
NPV (continue)

In other words:
Managers can increase shareholders’
wealth by accepting all projects that are
worth more than they cost.
Therefore, they should accept all
projects with a positive net present value
if there is no budget constraint.
Net Present Value

NPV = PV - required investment

C1 C2 Ct
NPV = C0 + + +...+
(1 + r ) 1
(1 + r ) 2
(1 + r ) t
Decision rule
⚫ If NPV > = 0, accept the project.
⚫ If NPV < 0, reject the project.
⚫ A positive NPV suggests that the project is
expected to add value to the firm, and the project
should improve shareholders’ wealth.
⚫ Because the goal of financial management is to
increase shareholders’ wealth, NPV is a good
measure of how well this project will meet this goal.
⚫ PVk = CFk/(1 + d)k , where k = 1, 2, 3, …..n
Net Present Value
⚫ The difference between the market value of
a project and its cost
⚫ Discounted Cash Flow (DCF) Valuation:
• 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.
 NPV – Decision Rule
⚫ If the NPV is positive, accept the project

⚫ 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.
Computing NPV for the Project
⚫ You are looking at a new project and you have
estimated the following cash flows:
• Year 0: CF = -165,000
• Year 1: CF = 63,120;
• Year 2: CF = 70,800;
• Year 3: CF = 91,080;
⚫ Your required return for assets of this risk is 12%.

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

– 165,000 = 12,627.42

⚫ Do we accept or reject the project?

Net Present Value

Example
You have the opportunity to
purchase an office building.
You have a tenant lined up
that will generate $16,000 per
year in cash flows for three
years. At the end of three
years you anticipate selling the
building for $450,000. How
much would you be willing to
pay for the building?
Net Present Value
$466,000
Example - continued

$450,000
$16,000 $16,000

$16,000

0 1 2 3
Net Present Value
$466,000

$450,000
Example - continued
$16,000 $16,000 $16,000

Present Value 0 1 2 3

14,953
14,953
380,395
$409,323
Net Present Value

Example - continued
If the building is being
offered for sale at a price
of $350,000, would you
buy the building and
what is the added value
generated by your
purchase and
management of the
building?
 Net Present Value

Example - continued
If the building is being offered for sale at a price of
$350,000, would you buy the building and what is the
added value generated by your purchase and
management of the building?

16,000 16,000 466,000

NPV = −350,000 + 1
+ 2
+ 3
(1.07 ) (1.07 ) (1.07 )
NPV = $59,323
Another example about NPV
⚫ An oil well, if explored, can now produce
100,000 barrels per year. The well will produce
forever, but production will decline by 4% per
year. Oil prices, however, will increase by 2%
per year. The discount rate is 8%. Suppose
that the price of oil now is $14 for barrel.
⚫ If the cost of oil exploration is $12.8 million, do
you want to take this project?
Solution
⚫ Visualize the cash flow patterns
⚫ C0=1.4, C1=1.37, C2=1.34, C3=1.31
⚫ What is the pattern of the cash flow?
• g=C1/C0 -1 =-0.0208=-2.1%
• PV( the project) =C0+C1/(r-g)=15
• NPV=PV( the project ) -12.8>0
⚫ What’s your decision?
 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
Two other investment rules
⚫ IRR rule
⚫ Payback period rule
IRR rule

Internal Rate of Return (IRR) – Single discount

rate at which NPV = 0.

IRR rule - Invest in any project offering a IRR

that is higher than the opportunity cost of
capital or the discount rate.
 Internal Rate of Return
⚫ Definition: IRR is the return that makes the NPV = 0
⚫ Decision Rule: Accept the project if the IRR is
greater than the required return
⚫ This is the most important alternative to NPV
• Often used in practice
• Intuitively appealing
• Based entirely on the estimated cash flows and is
independent of interest rates found elsewhere
⚫ Compute using trial and error process
IRR rule

Example
You can purchase a building for $350,000. The
investment will generate $16,000 in cash flows
(i.e. rent) during the first three years. At the
end of three years you will sell the building for
$450,000. What is the IRR on this investment?
 Internal Rate of Return

Example
You can purchase a building for $350,000. The investment will
generate $16,000 in cash flows (i.e. rent) during the first three
years. At the end of three years you will sell the building for
$450,000. What is the IRR on this investment?

16,000 16,000 466,000

0 = − 350,000 + + +
(1 + IRR ) 1
(1 + IRR ) 2
(1 + IRR ) 3
 Internal Rate of Return

Example
You can purchase a building for $350,000. The investment will
generate $16,000 in cash flows (i.e. rent) during the first three
years. At the end of three years you will sell the building for
$450,000. What is the IRR on this investment?

16,000 16,000 466,000

0 = − 350,000 + + +
(1 + IRR ) 1
(1 + IRR ) 2
(1 + IRR ) 3

IRR = 12.96%
Internal Rate of Return

200

150 IRR=12.96%
100
NPV (,000s)

50

0
0 5 10 15 20 25 30 35
-50

-100

-150

-200
Discount rate (%)
What’s wrong with IRR?
Pitfall 1 - Mutually Exclusive Projects
⚫ IRR sometimes ignores the magnitude of the project.

⚫ The following two projects illustrate that problem.

Example
You have two proposals to choose between.
The initial proposal (H) has a cash flow that
is different from the revised proposal (I).
Using IRR, which do you prefer?
Internal Rate of Return (1)

Example
You have two proposals to choose between. The initial
proposal (H) has a cash flow that is different from the revised
proposal (I). Using IRR, which do you prefer?

Project C0 C1 C2 C3 IRR NPV@7%

H -350 400 14.29% $ 24,000
I -350 16 16 466 12.96% $ 59,000
Internal Rate of Return

16 16 466
NPV = −350 + + + =0
1 2 3
(1 + IRR) (1 + IRR) (1 + IRR)
IRR = 12.96%

400
NPV = −350 + =0
(1 + IRR)1
IRR = 14.29%
 What’s wrong with IRR (2)?

Pitfall 2 - Lending or Borrowing?

Example

project C0 C1 IRR (%) NPV at 10%

J -100 +150 +50 +$36.4

K +100 -150 +50 -$36.4

What’s wrong with IRR (3)?
Pitfall 3 - Multiple Rates of Return
⚫ Certain cash flows can generate NPV=0 at two
different discount rates.
⚫ The following cash flow generates NPV=0 at both (-
50%) and 15.2%.
⚫ Example
• A project costs $1000 and produces a cash flow
of $800 in year 1, a cash flow of $150 every year
from year 2 to year 5, and a cash flow of -150 in
year 6.
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
 NPV Vs. IRR

⚫ NPV and IRR will generally give us the same

decision
⚫ Exceptions
• Non-conventional cash flows – cash flow signs
change more than once – may be several IRRs
• Mutually exclusive projects
• Initial investments are substantially different
• Timing of cash flows is substantially different
⚫ Whenever there is a conflict between NPV and
another decision rule, you should always use
NPV
Payback period rule

⚫ Payback period is the number of

periods such that cash flows recover
the initial investment of the project.
⚫ The payback rule specifies that a
project be accepted if its payback
period is less than the specified cutoff
period. The following example will
demonstrate the absurdity of this rule.
 Payback period rule

The following example shows that all the three projects have
a payback period of 2. If the payback period used by the
firm is 2, the firm can take project C and lose money.

Cash Flows
Prj. C0 C1 C2 C3 Payback NPV@10%
A -2000 +1000 +1000 +10000 2 7,429
B -2000 +1000 +1000 0 2 -264
C -2000 0 +2000 0 2 - 347
Some points to remember in
calculating free cash flows

⚫ Depreciation and accounting profit

⚫ Incremental cash flows
⚫ Change in working capital requirements
⚫ Sunk costs
⚫ Opportunity costs
⚫ Forget about financing
Cash flows, accounting profit
and depreciation
⚫ Discount actual cash flows
⚫ Using accounting income, rather than
cash flows, could lead to wrong
investment decisions
⚫ Don’t treat depreciation as real cash
flows
Example
⚫ A project costs $2,000 and is expected
to last 2 years, producing cash income of
$1,500 and $500 respectively. The cost
of the project can be depreciated at
$1,000 per year. Given a 10% required
return, compare the NPV using cash flow
to the NPV using accounting income.
Solution (using accounting
profit)

Year 1 Year 2
Cash Income $1500 $ 500
Depreciation - $1000 - $1000
Accounting Income + 500 - 500

500 − 500
Accounting NPV = + 2
= $41.32
1.10 (110
. )
Solution (using cash flows)
Today Year 1 Year 2
Cash Income $1500 $ 500
Project Cost - 2000
Free Cash Flow - 2000 + 1500 + 500

1500 500
Cash NPV = -2000+ 1
+ 2
= −$223.14
(1.10) (1.10)
Forget about financing

⚫ When valuing a project, ignore how the

project is financed.
⚫ You can assume that the firm is financed
by issuing only stocks; or the firm has no
debt but just equity
Incremental cash flows
⚫ Incremental cash flows are the increased
cash flows due to investment
⚫ Do not get confused about the average cost
or total cost?
⚫ Do you have examples about incremental
costs?

Incremental cash flow cash flow

Cash Flow = with project - without project
Working capital
⚫ Working capital is the difference between a
firm’s short-term assets and liabilities.
⚫ The principal short-term assets are cash,
accounts receivable, and inventories of raw
materials and finished goods.
⚫ The principal short-term liabilities are
accounts payable.
⚫ The change in working capital represents
real cash flows and must be considered in
the cash flow calculation
Example
⚫ We know that inventory is working
capital. Suppose that inventory at year 1
is $10 m, and inventory at year 2 is $15.
What is the change in working capital?
Why does this change represent real
cash flows?
Sunk costs
⚫ The sunk cost is past cost and has
nothing to do with your investment
decision
⚫ Is your education cost so far at SFSU is
sunk cost?
Opportunity cost
⚫ The cost of a resource may be relevant
to the investment decision even when no
cash changes hands.
⚫ Give me an example about the
opportunity cost of studying at SFSU?
Inflation rule

⚫ Be consistent in how you handle inflation!!

⚫ Use nominal interest rates to discount
nominal cash flows.
⚫ Use real interest rates to discount real
cash flows.
⚫ You will get the same results, whether you
use nominal or real figures
Example

You own a lease that will cost you $8,000 next

year, increasing at 3% a year (the forecasted
inflation rate) for 3 additional years (4 years
total). If discount rates are 10% what is the
present value cost of the lease?

1+nominal interest rate

1 + real interest rate = 1+inflation rate
Inflation
Example - nominal figures
Year Cash Flow PV @ 10%
1.10 = 7272.73
8000
1 8000
2 8000x1.03 = 8240 8240
1.102
= 6809.92
3 2
8000x1.03 = 8240 8487 .20
1.103
= 6376.56
4 3
8000x1.03 = 8487.20 8741 .82
1.104
= 5970.78
$26,429.99
Inflation
Example - real figures

Year Cash Flow [email protected]%

1.068 = 7272.73
8000 7766.99
1 1.03 = 7766.99

2 8240
1.032
= 7766.99 7766.99
1.0682
= 6809.92
3 8487.20
1.033
= 7766.99 7766.99
1.0683
= 6376.56
4 = 5970.78
8741.82 7766.99
4 1.034 = 7766.99 1.068
= $26,429.99
How to calculate free cash
flows?
⚫ Free cash flows = cash flows from
operations + cash flows from the change
in working capital + cash flows from
capital investment and disposal
• We can have three methods to calculate cash
flows from operations, but they are the exactly
same, although they have different forms.
How to calculate cash flows
from operations?
⚫ Method 1
• Cash flows from operations =revenue –cost
(cash expenses) – tax payment
⚫ Method 2
• Cash flows from operations = accounting
profit + depreciation
⚫ Method 3
• Cash flows from operations =(revenue –
cost)*(1-tax rate) + depreciation *tax rate
Example

revenue 1,000
- Cost 600
- Depreciation 200
- Profit before tax 200
- Tax at 35% 70
- Net income 130

Given information above, please use three methods to calculate

Cash flows
Solution:
⚫ Method 1
• Cash flows=1000-600-70=330
⚫ Method 2
• Cash flows =130+200=330
⚫ Method 3
• Cash flows =(1000-600)*(1-0.35)+200*0.35
=330
A summary example ( Blooper)
⚫ Now we can apply what we have
learned about how to calculate cash
flows to the Blooper example, whose
information is given in the following
slide.
 Blooper Industries

Year 0 1 2 3 4 5 6
Cap Invest 10,000
WC 1,500 4,075 4,279 4,493 4,717 3,039 0
Change in WC 1,500 2,575 204 214 225 − 1,678 − 3,039
Revenues 15,000 15,750 16,538 17,364 18,233
Expenses 10,000 10,500 11,025 11,576 12,155
Depreciation 2,000 2,000 2,000 2,000 2,000
Pretax Profit 3,000 3,250 3,513 3,788 4,078
.Tax (35%) 1,050 1137
, 1,230 1,326 1,427
Profit 1,950 2,113 2,283 2,462 2,651
(,000s)
Cash flows from operations for
the first year
Revenues 15,000
- Expenses 10,000
− Depreciation 2,000
= Profit before tax 3,000
.-Tax @ 35 % 1,050
= Net profit 1,950
+ Depreciation 2,000
= CF from operations 3,950 or $3,950,000
 Blooper Industries

Net Cash Flow (entire project) (,000s)

Year 0 1 2 3 4 5 6
Cap Invest -10,000
Change in WC -1,500 - 2,575 - 204 - 214 - 225 1,678 3,039
CF from Op 3,950 4,113 4,283 4,462 4,651
Net Cash Flow -11,500 1,375 3,909 4,069 4,237 6,329 3,039

NPV @ 12% = $3,564,000

NPV vs. Other Rules

⚫ Advantages of NPV ⚫ Disadvantages of

• Accounts for time NPV
value of money and
risk • May be difficult to
communicate
• Does not requires an
• May be difficult to
arbitrary cutoff point
calculate
• Balances long-term
• Does not account for
and short-term goals
liquidity needs
• Based on market
values, not
accounting values
 Course Project Assignment
(Submission date: Last week of
Lectures)
⚫ A power generation company is considering expanding its
generation capacity by 30%. The expansion will require $50 million
initially. The net cash flow from this expansion is $4 million for the
first year. The net cash flows are expected to grow at a rate of 5%
each year for 4 years, but then slow to a 3% growth thereafter. The
project has an infinite life. The Company estimates that the cost of
capital (i.e., required return) for this expansion is 8%.
⚫ Task: write a report answering (1) should the company expand?
Why? (2) If the market interest rate increases and thus the cost of
capital for this expansion increases to 12%, would your
recommendation change?
⚫ You would need to use the growing perpetuity equation for this
assignment.