Cash Flow Estimation Session 30

8/3/2019 Cash Flow Estimation Session 30

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Session 30

Capital Budgeting


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Who estimate?

Capital outlays-----engineering and product outlaydept.

Revenue projectionmarketing group Operating cost----- production dept. cost

accountants, purchase manager, personnel exe, taxexpert

Finance manager coordinate the efforts Minimizes the biases inherent in cash flow

forecasting


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Investment Project Proposals

New Product

Expansion of Existing Product Replacement

Research and Development


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Basic principles Separation Principle

Incremental Principle

Post tax Principle

Consistency Priciple


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Separation Principle

Profit after tax + interest(1- tax rate)


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Incremental Principle

Guidelines:

Consider all incidental effects

Ignore sunk cost

Include opportunity cost

Question of allocation of overhead cost

Estimate working capital properly Includeproject-driven changes in working capitalchanges in working capital net of

spontaneous changes in current liabilities


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Post tax principle

Since taxes are cash

flows, we must include taxes in our cash

flow estimates. All estimated cash flows should be after-taxcash flow estimates!

Effect of non cash charges

DepreciationDepreciation represents the systematic allocation of thecost of a capital asset over a period of time for financialreporting purposes, tax purposes, or both.

Everything else equal, the greater the depreciation charges, thelower the taxes paid by the firm.

Depreciation is a non-cash expense.


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Consistency Principle Cash flows and discount rate must be

consistent with respect to inflation

Cash flow discount rate

Nominal Cash flow nominal discount rate

Real Cash flow real discount rate


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Elements of Cash

Flow Stream Initial investment

Operating cash flow

Terminal cash

flow Net salvage value of fixed asset + net recovery

of working capital margin


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Biases in cash

flow estimation Overstatement of profitability

Intentional overstatement

Lack of experience

Understatement of profitability

Salvage values are under estimated

Intangible benefits are ignored


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Initial Cash OutflowInitial Cash Outflowa) Cost of new assetsCost of new assets

b) + Capitalized expenditures

c) + (-) Increased (decreased) NWCd) - Net proceeds from sale of

old asset(s) if replacement

e) + (-) Taxes (savings) due to the sale

of old asset(s) if replacementf) == Initial cashInitial cashoutflowoutflow


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Incremental Cash FlowsIncremental Cash Flowsa) Net incr. (decr.) in operating revenue

less (plus) any net incr. (decr.) in

operating expenses, excluding depr.

b) - (+) Net incr. (decr.) in tax depreciationc) = Net change in income before taxes

d) - (+) Net incr. (decr.) in taxes

e) = Net change in income after taxes

f) + (-) Net incr. (decr.) in tax depr. Charges

g) == Incremental net cash flow for periodIncremental net cash flow for period


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TerminalTerminal--YearYear

Incremental Cash FlowsIncremental Cash Flowsa) Calculate the incremental net cashincremental net cash

flowflow for the terminal periodterminal period

b) + (-) Salvage value (disposal costs) of any sold or disposed

assetsc) - (+) Taxes (tax savings) due to asset sale or disposal of

new assets

d) + (-) Decreased (increased) level of net

working capitale) == Terminal year incremental net cash flowTerminal year incremental net cash flow


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Example of an AssetExample of an Asset

Expansion ProjectExpansion ProjectX Ltd is considering the purchase of a new basket weaving machine.

The machine will cost Rs.50,000 plus Rs.20,000 for shipping and

installation and falls under the 3-year MACRS class. NWC will rise

by Rs.5,000. Mr. Sengupta forecasts that revenues will increase byRs.110,000 for each of the next 4 years and will then be sold

(scrapped) for Rs.10,000 at the end of the fourth year, when the

project ends. Operating costs will rise by Rs.70,000 for each of the

next four years. X Ltd. is in the 40% tax bracket.


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Initial Cash OutflowInitial Cash Outflowa) Rs.50,000

b) + 20,000

c) + 5,000d) - 0 (not a replacement)

e) + (-) 0 (not a replacement)

f) == Rs.75,000Rs.75,000


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Incremental Cash FlowsIncremental Cash FlowsYear 1 Year 2 Year 3 Year 4

a) Rs.40,000 Rs.40,000 Rs.40,000 Rs.40,000

b) - 23,331 31,115 10,367 5,187

c) = Rs.16,669 Rs. 8,885 Rs.29,633 Rs.34,813

d) - 6,668 3,554 11,853 13,925

e) = Rs.10,001 Rs. 5,331 Rs.17,780 Rs.20,888

f) + 23,331 31,115 10,367 5,187

g) == Rs.33,332 Rs.36,446 Rs.28,147 Rs.26,075Rs.33,332 Rs.36,446 Rs.28,147 Rs.26,075


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Incremental Cash FlowsIncremental Cash Flowsa) Rs.26,075Rs.26,075 The incremental cash flowincremental cash flow

from the previous slide in

Year 4.

b) + 10,000 Salvage Value.c) - 4,000 .40*(Rs.10,000 - 0) Note, the

asset is fully depreciated at

the end ofYear 4

d) + 5,000 NW

C - Project ends.

e) == Rs.37,075Rs.37,075 TerminalTerminal--year incrementalyear incremental

cash flowcash flow..


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Summary of ProjectSummary of Project

Net Cash FlowsNet Cash FlowsAsset Expansion

Year 0 Year 1 Year 2 Year 3 Year 4

--Rs.75,000Rs.75,000 Rs.33,332Rs.33,332 Rs.36,446 Rs.28,147 Rs.37,075Rs.36,446 Rs.28,147 Rs.37,075


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Example of an AssetExample of an Asset

Replacement ProjectReplacement ProjectLet us assume that previous asset expansion project is actually an asset

replacement project. The original basis of the machine was Rs.30,000

and depreciated using straight-line over five years (Rs.6,000 per year).

The machine has two years of depreciation and four years of useful liferemain-ing.X Ltd. can sell the current machine for Rs.6,000. The new

machine will not increase revenues (remain at Rs.110,000) but it

decreases operating expenses by Rs.10,000 per year (old = Rs.80,000).

NWC will rise to Rs.10,000 from Rs.5,000 (old).


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Calculation of theCalculation of the

Change in DepreciationChange in DepreciationYear 1 Year 2 Year 3 Year 4

a) Rs.23,331 Rs.31,115 Rs.10,367 Rs. 5,187

b) - 6,000 6,000 0 0

c) = Rs.17,331 Rs.25,115 Rs.10,367 Rs. 5,187Rs.17,331 Rs.25,115 Rs.10,367 Rs. 5,187

a) Represent the depreciation on the new project.

b) Represent the remaining depreciation on the old project.

c) Net changechange in tax depreciation charges.


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Incremental Cash FlowsIncremental Cash FlowsYear 1 Year 2 Year 3 Year 4

a) Rs.10,000 Rs.10,000 Rs.10,000 Rs.10,000

b) - 17,331 25,115 10,367 5,18717,331 25,115 10,367 5,187

c) = Rs. -7,331 -Rs.15,115 Rs. -367 Rs. 4,813

d) - -2,932 -6,046 -147 1,925

e) = Rs. -4,399 Rs. -9,069 Rs. -220 Rs. 2,888

f) + 17,33117,331 25,11525,115 10,367 5,18710,367 5,187

g) == Rs.12,932 Rs.16,046 Rs.10,147 Rs. 8,075Rs.12,932 Rs.16,046 Rs.10,147 Rs. 8,075


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Incremental Cash FlowsIncremental Cash Flowsa) Rs. 8,075Rs. 8,075 The incremental cash flowincremental cash flow

from the previous slide in

Year 4.

b) + 10,000 Salvage Value.c) - 4,000 (.40)*(Rs.10,000 - 0). Note, the

asset is fully depreciated at

the end ofYear 4.

d) + 5,000 Return of added NW

C.e) == Rs.19,075Rs.19,075 TerminalTerminal--year incrementalyear incremental

cash flow.cash flow.


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Summary of ProjectSummary of Project

Net Cash FlowsNet Cash FlowsAsset Expansion



Asset Replacement




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Recapitulation Basic characteristics of relevant project flows

Cash (non accounting flows)

Operating ( non financing Flows)

After tax flows

Incremental flows


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Equivalent Annual CostEquivalent Annual Cost - The cost per period

with the same present value as the cost of

buying and operating a machine.


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Equivalent Annual CostEquivalent Annual Cost - The cost per period

with the same present value as the cost of

buying and operating a machine.

Equivalent annual cost =present value of costs

annuity factor


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Example

Given the followingcosts of operatingtwo machines

anda 6% cost ofcapital, select thelowercostmachine

usingequivalent annualcostmethod.

Year

Machine 1 2 3 4 PV@6% EAC

A 15 5 5 5 28.37 10.61

B 10 6 6 21.00 11.45

Equivalent Annual Cost


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Timing Even projects with positive NPV may be

more valuable if deferred.

The actual NPV is then the current value of

some future value of the deferred project.

trt

)1(dateofasvaluefutureNetNPVCurrent

!


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TimingExample

You may harvest a set of trees at anytime over the

next 5 years. Given the FV of delaying theharvest, whichharvest date maximizes current

NPV?

0 1 2 3 4 5

Net FV (Rs.1000s) 50 64.4 77.5 89.4 100 109.4

% change in value 28.8 20.3 15.4 11.9 9.4

Harvest Y ear


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TimingExample - continued

You may harvest a set of trees at anytime over the next 5 years. Given

the FV of delaying the harvest, whichharvest date maximizes currentNPV?

5.581.10

64.41yearinharvestedif !!NPV


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TimingExample - continued

You may harvest a set of trees at anytime over the next 5 years. Given

the FV of delaying the harvest, whichharvest date maximizes currentNPV?

5.581.10

64.41yearinharvestedif !!NPV

0 1 2 3 4 5

NPV (Rs.1000s) 50 58.5 64.0 67.2 68.3 67.9

Harve st Y ear


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Fluctuating Load Factors

Two Old Machines

Annual output per machine 750 units

Operating cost per machine 2 750 .1,500

PV operating cost per pachine 1,500/.10 .15,000

PV operating cost of two mach

ines 2 15,000 .30,000

Rs

Rs

Rs

v !

!

v !


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Fluctuating Load FactorsTwo New Machines

Annual output per machine 750 units

Capital cost per machine .6,000Operating cost per machine 1 750 .750

PV operating cost per pachine 6,000 750/.10 .13,500

PV operating cost of two mac

RsRs

Rs

v !

!

hines 2 13,500 .27,000Rsv !


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Fluctuating Load Factors

One Old Machine One New Machine

Annual output per machine 500 units 1,000 units

Capital cost per machine 0 .6,000

Operating cost per machine 2 500 .1,000 1 1,000 .1,000

PV operating cost per machine 1,000/.

Rs

Rs Rsv ! v !

10 .10,000 6,000 1,000 / .10 .16,000

PV operating cost of two machines ................................ .26,000

Rs Rs

Rs

! !


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Recapitulation Basic principles that must be adhered to in

estimating after tax incremental cash flows

Ignore sunk cost

Include opportunity cost

Include project driven changes in NWC

Includes effects ofInflation


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Documents

Cash Flow Estimation Session 30