Cash Flow Estimation and Other Issues in Capital Budgeting (thru

page 398 plus 406-7) plus Appendices 12-A and 12-B

Chapter 12

OverviewCash Flow Estimation

New or Expansion ProjectOther Cash Flow Estimation IssuesReplacement Project

Capital Budgeting Steps For a potential project:1. Forecast the project cash flows.2. Estimate the cost of capital3. Discount the future cash flows at the cost

of capital.4. Find NPV of project = PV of future cash

flows – required investment, and accept if NPV > 0.

Cash Flow EstimationNeed to estimate incremental after taxincremental after tax

cash flowscash flows that the project is expected to generate.

General form: Cash Flow = Incremental Net Income + Depreciation

Other “special” cash flowsInitial costsExtra ending or terminal cash flows at the

end of the project’s expected useful life.

Incremental Cash Flows

IMPORTANTIMPORTANTAsk yourself this question

Would the cash flow still exist if the project does not exist?

If yes, do not include it in your analysis.If no, include it.

Secret Documents from Jelly Donut. The Sun Blocker Project: What was Mr. Burns thinking?In planning construction of the Sun Blocker, my

engineers and I determined that the Sun Blocker would cost $50 million to build today (t=0). The estimated useful life for Sun Blocker is 3 years with no expected salvage value at the end of the project’s useful life. My assistant, Smithers, thought Sun Blocker’s cost wouldn’t qualify for annual depreciation write offs due to its nefarious nature. “Pish-posh” I said, ordering Smithers to look into this matter further. After further research, Smithers reports that Sun Blocker qualifies for the 3-year MACRS depreciation class. Smithers also reports that the marketing department spent $1 million commissioning a electricity demand sensitivity analysis for the project. I fire the entire department and replace them with that Simpson chap since he always seems deep in thought.

Sun Blocker InfoOne of my underlings from the collections

department now informs me that we will need an increase in working capital at the beginning of the project of $8 million. Before I have a chance to fire him, he quickly adds that this increased investment in working capital can be sold at the end of the project’s life. I let him keep his job for now, and go back to the drawing board.

Sun Blocker InfoMy marketing and production staff estimate

that Sun Blocker will increased need for electricity and will increase revenues and operating costs of $80 million and $15 million respectively for each of the next 3 years. Our company’s despicable combined federal and state income tax rate is 40%, and our opportunity cost of capital is 11%.

What are the expected cash flows for this project and should Mr. Burns go ahead with Sun Blocker?

Estimate Cash Flowsa) Initial Outlay: What is the cash flow at

“time 0?”General Steps (Purchase price of the asset)+ (shipping and installation costs) (Depreciable asset)+ (Investment in working capital) Net Initial Outlay

Investment in Net Operating Working Capital(Net) Working Capital = Current Assets –

Current LiabilitiesMost new projects require additional short-term

(current) assets and often additional current liabilities, such asAdditional receivables from increased credit sales.Additional inventory (raw materials) necessary to

produce additional new products.Additional trade credit (accounts payables) and taxes

and wages payable.Any needed increase in net operating working

capital is an outflow of cash, but these outflows are recovered by the end of the project.

Initial Outlay for Sun Blocker (t=0)

Estimating Cash FlowsAnnual Operating Cash Flows: What

incremental cash flows occur over the life of the project?

For Each Year, Calculate:

Incremental revenue- Incremental costs- Depreciation increase on project Incremental earnings before taxes- Tax on incremental EBT Incremental earnings after taxes+ Depreciation increase

Annual Operating Cash Flow

Sun Blocker Annual Depreciation

Depreciable Asset (cost) = $50 million3-year MACRS depreciation.Year MACRS% X Cost = Depreciation 1 33% 50 16.5 2 45% 50 22.5 3 15% 50 7.5 4 7% 50 3.5 =

BV3

Annual Operating CFs ($millions) for Sun Blocker

Estimating Terminal, End of Project Cash Flows

c) Terminal Cash Flow: What is the cash flow at the end of the project’s life?

Salvage value-/+ Tax effects of new capital gain/loss

on salvage value

+ Recovery of all increase in net operating working capital

= Terminal Cash Flow

Sun Blocker Terminal CF (end of yr 3)Salvage Value = 0 BV3 = 3.5

Plunge Springfield in Darkness?Year Cash Flow

0123

NPV at 11% =IRR = MIRR =

Today’s AgendaOther Cash Flow Estimation IssuesReplacement Project Cash Flow AnalysisTop 10 List Review/3 Key Things to

Remember

Other Incremental Cash Flow IssuesSunk costs = exclude. Ask yourself if

rejecting the project affects this cost.Financing costs, such as interest expense =

EXCLUDE. Already included in WACC.Opportunity Costs = INCLUDE. Generally

revenues forgone from using land or building for another purpose other than the project.

Other Incremental Cash Flow Issues (continued)Externalities = effects of a project on cash

flows in other part of the firm. Can be positive or negative and should be INCLUDED as part of the project’s incremental cash flows.

Cannibalization = INCLUDE. A negative externality, occurs when the introduction of a new product diminishes the sales of existing products.

Replacement Project CF AnalysisAssume old project is sold today and

replaced be the new one.Receive inflow from the sale of old project

today, but give up any future expected inflows (opportunity costs).

General form: Increase in Net Income + (Depreciation on New - Depreciation on Old)

Imperial Defense Co. Death Star Replacement ProjectSix years ago in a galaxy far, far away, the

Imperial Defense Co. (IDC) built the original Death Star at a cost of $100 billion. This original project is being depreciated on a straight-line basis over a 10-year period to zero.

IDC is considering building a new and improved Death Star at a cost of $200 billion. The old death star can be sold for scrap today for $20 billion.

IDC Death Star Replacement Project Info (cont.)The new Death Star is estimated to have a 4-

year useful life and falls into the 3-yr MACRS depreciation class. The new Death Star is expected to increase “protection” revenues by $60 billion in year 1and by $90 billion in years 2 thru 4. Rebel defense expenses are expected to increase by $10, $20, $30 and $40 billion in years 1 thru 4 respectively.

The new Death Star has an estimated salvage value of $30 billion at the end of its 4-yr useful life and the original Death Star has a $6 billion salvage value at the end of its useful life.

Death Star Replacement Project TasksEstimate the cash flows of the replacement

project assuming a marginal tax rate of 40%.

Should the old Death Star be replaced if Imperial Defense Co.’s cost of capital is 10%.

Death Star Replacement Project’s initial Cash Flow($billion)Sell old for $20 (original cost $100), buy new for

$200Book Value of old = $100 - ($100/10 x 6) = $40Buy NewSale of OldTaxes on Sale of Old

Total

Death Star Replacement Project DepreciationAnnual Depreciation on Old = 100/10 =$10

Depr.Year Dep% Base New Dep Old Dep Diff.1 33% 200 66 10 562 45% 200 90 10 803 15% 200 30 10 204 7% 200 14 10 4

Death Star Replacement Project Operating Cash FlowsYear 1 2 3 4Rev-Exp-DepDiff 56 80 20 4EBT-Tax(40%)Net Income+DepDiffCash Flow

Death Star Replacement Terminal Cash Flowsat t=4, New Salvage Value = $30, New Book

Value = 0Old Salvage Value = $6, Old Book Value = 0New Salvage Value-Taxes on New SV = .4(30-0)-Old Salvage Value+Taxes on Old SV = .4(6-0)Total Terminal CF (t = 4)

Death Star Replacement Project Decision Time (Billions)Year Cash Flow0 -172.01 52.42 74.03 44.04 OCF4+TCF = 31.6+14.4 =

46.0

NPV at 10% = 1.27B, IRR = 10.4%, MIRR = 10.2%

3 Key Things to RememberGoal of the Firm is to maximize stockholder

wealth (stock price).Bond prices and interest rates have an

inverse relationship.To enhance wealth select positive NPV

investments.