Introduction to Corporate Finance

10: Cash Flow and Capital Budgeting

In year 6, the project generates a net cash inflow of $40,485. Assuming that cash flows beyond the

sixth year grow at 4% per year, and discounting those cash flows at 15%, we can use the equation for a

growing perpetuity (Equation 3.11, on page 94) to determine the terminal value of the project as of the

end of year 6, as follows:

Terminal value
$42,104
0.15 0.04

= $382, 764

−

=

Notice that the numerator of $42,104 in the expression above is the estimated year 7 cash flow, which

is 4% greater than the cash flow in year 6 (1.04 × $40,485 = $42,104). Remember (from Chapter 3,

Equation 3.11, and Chapter 5, Equation 5.4), when valuing a stream of cash flows that grows at a

perpetual rate, the value today equals next year’s cash flow divided by the difference between the discount

rate and the growth rate. Thus, to determine the terminal value in year 6, we must use the cash flow in

year 7 in the numerator.

As a second approach, assume that the terminal value of the project simply equals the book value

at the end of year 6. At that time, the company has fully depreciated its investment in computers, so its

only assets are cash ($3,500), receivables ($28,125) and inventory ($42,188). Offsetting those assets are

$24,300 in accounts payable, so the book value of the venture is just $49,513, a far cry from our prior

terminal value estimate. The magnitude of that difference should not surprise us too much. In general,

as noted in Chapter 5, a profitable, growing business will have a market value that exceeds its book value.

A third way to estimate the project’s terminal value is to use a market multiple approach. A Protect

IT analyst could multiply the project’s expected sales, earnings or cash flow in year 6 times a market

multiple based on comparable companies. For example, suppose that at the present time, companies

that make accessories for the iPad sell at a price-to-sales ratio of about 1.5. Table 10.3 projects that

in six years the line of protective covers will generate $337,500 in revenue. Multiplying this times 1.5

suggests that the product line could be worth $506,250 at the end of year 6. Clearly, different methods

of calculating a project’s terminal value can lead to very different estimates.

10-3e PrOTECT IT PrOJECT NPV

Putting all this together, we arrive at different estimates of the project’s NPV, depending on which

estimate of terminal value we use. Assuming that this business will continue to increase profits forever,

we arrive at the following NPV:

NPV =−++++++

+

$53,000 =

$3,372

1.15

$9,387

1.15

$18,673

1.15

$29,179

1.15

$40, 043

1.15

$40, 485 $382,764

1.15

123456 $188,^882

On the other hand, if we assume that the terminal value is only equal to book value after six years,

then we arrive at the following NPV:

NPV (^) =−++++++

• $53,000 =
  $3,372
  1.15
  $9,387
  1.15
  $18,673
  1.15
  $29,179
  1.15
  $40, 043
  1.15
  $40, 485 $49,513
  1.15
  123456 $44,^808
  In this example, the project yields a positive NPV, no matter which terminal-value estimate we choose,
  so investing in the new product line will increase shareholder wealth. However, in many real-world
  situations, especially those involving long-lived investments, the ‘go’ or ‘no-go’ decision will depend critically
  on terminal-value assumptions. It is not at all uncommon for the perpetual growth and market multiple
  approaches to yield positive NPVs, while the book value approach shows a negative NPV. In that case,
  managers have to think more deeply and realistically about the long-run value of their enterprise.
  David Nickel, Controller
  for Intel Communications
  Group, Intel Corp.
  ‘Capital budgeting is the
  key theme for deciding
  which programs get
  funded.’
  See the entire interview on
  the CourseMate website.
  COUrSEMATE
  SMArT VIDEO
  Source: Cengage Learning