1 CHAPTER 11 Cash Flow Estimation. 2 Topics Estimating cash flows: Initial investment Operating cash...

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CHAPTER 11

Cash Flow Estimation

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Topics

Estimating cash flows: Initial investment Operating cash flows Non-operating cash flows

4-step procedure

Initial investment outlay Operating cash flows in the

following years Non-operating cash flows in the

last year apply NPV and other methods to

evaluate the project

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Estimating cash flows guidelines 1All project cash flows must be incremental

For initial outlay Include opportunity costs Include changes in net working capital Ignore sunk costs

Estimating cash flows guidelines 1All project cash flows must be incremental

For operating cash flow Include opportunity costs Add back depreciation to net income Ignore interest expense Ignore allocated costs

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Estimating cash flows guidelines 3All project cash flows must be incremental

non-operating cash flows in the last year

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All cash flows must be incremental

To evaluate a project, we look at the cash flows which it contributes towards the firm’s existing cash flows. In other words, we look at project’s incremental cash flows.

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Opportunity costs wrt initial outlay Suppose the project requires the use of

some asset owned by the firm. If the asset is not used by the project,

the firm can sell the asset for $X. This $X is the opportunity cost of the asset. Such a cost should be included in the project’s cost.

An asset’s opportunity cost is the money that the firm can receive if the asset is put to the next best use. The ‘next best’ use may be to sell the asset.

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Changes in net working capital

Very often, a project will require an initial increase in net working capital. This increase in net working capital must be added to the project’s costs. (changes in AR, Inv, AP, accruals, minimum cash balance)

This additional working capital is recovered at the end of the project’s life, which is a non-operating cash inflow in the last year.

Sunk costs 1

costs which cannot be recovered regardless of whether the firm undertakes the project.

Examples: R&D expenses, consultant fees incurred already

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Sunk Costs 2 Suppose $100,000 had been spent last

year to improve the production line site. Should this cost be included in the analysis?

NO. This is a sunk cost.

Cannibalization Net sales after cannibalization

If the new product line would decrease sales of the firm’s other products by $50,000 per year, would this affect the analysis?

Yes. Net CF loss per year on other lines would be a cost to this project. 12

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Depreciation

Depreciation is a non-cash charge and must be added to net income to estimate cash flow.

Operating Cash flow = net income + depreciation expense

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Opportunity Costs wrt operating cash flows Suppose the plant space could be

leased out for $25,000 a year. Would this affect the analysis?

Yes. Accepting the project means we will not receive the $25,000. This is an opportunity cost and it should be charged to the project.

After-tax opportunity cost = $25,000 (1 – T) = $15,000 annual cost.

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Ignore allocated costs

Allocated costs: current rent, supervisory salaries, administrative costs, and various overhead expenses.

These costs are not incremental. Thus, they should not be considered in estimating the project’s incremental cash flows.

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Ignore interest expense

WACC includes the interest expenses.

In determining a project’s cash flows, we ignore it’s financing cost, i.e., the interest expense.

Non-operating cash flows

The incremental net working capital at t=0 is recovered at the end of the project’s life, which is a non-operating cash inflow in the last year.

After-tax salvage value

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After-tax salvage cash flow

Salvage Value $25- Book Value 0 Gain or loss $25- Tax(40%) 10

$15

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Question 1Thompson Company has to decide whether to build a new factory. Management has collected various cost data to use to make the decision. Some of the items collected are listed below. Which of the following should Thompson consider as being relevant for computing cash flows for the new factory project?

A. $500,000 was spent last year to upgrade a piece of property on which the company is planning to build the new factory.

B. It will cost $10,000,000 to construct the factory and new equipment costing $3,250,000 will need to be purchased and installed to begin production of the product to be sold.

C. The factory construction costs of $10,000,000 will be financed entirely with new long-term debt (specifically a new bond issue). The company estimates that the interest costs of this new debt will be $850,000 per year.

D. The variable cost of production is estimated to be 65% of annual sales.E. The accounting department plans to allocate supervisory and

management costs of $25,000 per year to the project. No new supervisory or management personnel will be required.

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Question 2Investment in land and building: 200,000Changes in net working capital: 8,000 increase in inventory, 3,500 increase in minimum cash balance, 18,000 increase in account receivable, 2,500 increase in account payable, 500 increase in accruals. The total amount will be recovered at the end of life of project. What is the initial change in net working capital?

Answer: 8000+3500+18000-2500-500=26,500

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Capital budgeting example 1

You are given the responsibility of conducting the project selection analysis in your firm. You have to calculate the NPV of a given project. The appropriate cost of capital is 12 percent and the firm is in the 30 percent tax bracket. You are provided the following pieces of information regarding the project:

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Details The project is going to be built on a

piece of land that the firm already owns. The market value of the land is $1 million.

If the project is undertaken, prior to construction, an amount of $100,000 would have to be spent to make the land usable for construction purposes.

In order to come up with the project concept, the company had hired a marketing research firm for $200,000.

The firm has spent another $250,000 on R&D for this project.

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Details The project will require an initial outlay

of $20 million for plant and machinery. The sales from this project will be $15

million per year of which 20 percent will be from lost sales of existing products.

The variable costs of manufacturing for this level of sales will be $9 million per year.

The company uses straight-line depreciation. The project has an economic life of ten years and will have a before-tax salvage value of 3 million at the end.

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Details Because of the project the company will

need additional working capital of $1 million which can be liquidated at the end of ten years.

The project will require additional supervisory and managerial manpower that will cost $200,000 per year.

The accounting department has allocated $350,000 as allocated overhead cost for supervisory and managerial salaries.

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Calculate initial cost Initial cost is the sum of:

• Market value of land: $1 mil (opportunity cost)

• Land improvement $100 k• Plant & machinery: $20 mil• Incremental working capital: $1 mil

Initial cost = 1,000,000 + 100,000 + 20,000,000 +

1,000,000= $22,100,000

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Calculate the annual incremental cash flow: step 1

Calculate the annual depreciation expenseFor this project, fixed assets refer to $20mil plant & machinery. Therefore, Depreciation = (20,000,000 – 3,000,000)/10= $1,700,000

Calculate incremental salesIncremental sales = 0.8 x 15,000,000 = $12,000,000

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Calculate the annual incremental cash flow: step 2

Draw up the incremental income statement

Incremental sales 12,000,000

Less Incremental variable cost 9,000,000

Less Incremental managerial salaries 200,000

Less Incremental depreciation 1,700,000

Equals Incremental taxable income 1,100,000

Less Incremental tax @30% 330,000

Equals Incremental net income 770,000

Add back depreciation 1,700,000

Incremental cash flow $2,470,000

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Step 3: non-operating cash flows

At the end of project’s life (t=10), company

• Recovers $1 mil additional working capital (item 9)

• Receives $3x(1-0.3)=2.1 mil after-tax salvage value from plant & machinery (item 8)

Additional cash flows at end of project = 1,000,000 + 2,100,000 = $3,100,000

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Step 4

CF0 (initial cost) = $22,100,000

Annual incremental after-tax cash flow (Year 1 through Year 10) = $2,470,000

Nonoperating cash flow in Year 10 = $3,100,000

So in year 10, the company receives a total of = 2,470,000 + 3,100,000 = $5,570,000

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Step 4

To compute NPV, enter cash flows in this way: CF0 = -22,100,000 C01 = 2,470,000, F01=9C02 = 5,570,000, F02=1

Then press NPV, enter I = 12, press CPT and NPV.

NPV = -$7,145,832.09Decision: reject the project.

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Capital budgeting example 2

ABC Corp. manufactures television sets and computer monitors. The company is considering introducing a new 40” flat screen television/monitor. The company’s CFO has collected the following information about the proposed product.

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Details

1) The project has an anticipated economic life of 5 years.

2) The company will have to purchase a new machine to produce the screens. The machine has an up front cost (t = 0) of $4,000,000. The machine will be depreciated on a straight-line basis over 5 years. The company anticipates that the machine will last for five years and then have no salvage value (that is, it will be worthless).

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Details

3) If the company goes ahead with the proposed product, it will have to increase inventory by $280,000 and accounts payable by $80,000. At t = 5, the net working capital will be recovered after the project is completed.

4) The screen is expected to generate sales revenue of $2,000,000 the first year; $4,500,000 the second through fourth years and $3,000,000 in the fifth year. Each year the operating costs (excluding depreciation) are expected to equal 50% of sales revenue.

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Details

5) The company’s interest expense each year will be $350,000.

6) The new screens are expected to reduce the sales of the company’s large screen TV’s by $500,000 per year.

7) The company’s cost of capital is 12%.8) The company’s tax rate is 30%.

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Questions

What is the initial investment for the project?

What is the 3rd year expected incremental operating cash flow? (i.e., the incremental after tax cash flow)

What is the 5th year incremental non-operating cash flow?

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Q1: initial investment

To answer Q1, you need points 2 & 3.

Initial investment= machine cost + change in net working

capital= 4,000,000 + (change in current assets – change in current

liabilities)= 4,000,000 + (280,000 – 80,000)= $4,200,000

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Q2: 3rd incremental operating cash flow

To answer Q2, you need points 2,4,6,8.Steps:1) Incremental sales = 4,500,000 – 500,000 = 4,000,0002) Annual depreciation = (4,000,000)/5 =

800,0003) Incremental operating cost for 3rd year = 0.5 x 4,500,000 = 2,250,000Next, draw up the incremental income statement

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Incremental sales 4,000,000

Less Incremental operating cost 2,250,000

Less Incremental depreciation 800,000

Equals Incremental taxable income 950,000

Less Incremental tax @30% 285,000

Equals Incremental net income 665,000

Add back depreciation 800,000

Incremental cash flow $1,465,000

Q2: 3rd incremental operating cash flow

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Q3: 5th year incremental non-operating cash flow

Very simple. The only incremental non-operating cash flow is the cash flow from liquidating the increase in net working capital (point 3).

5th year incremental non-operating cash flow = $200,000

Homework assignment

Problems: 1, 2, 3, 7.

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