Transcript Chapter 12 - Washington State University

Estimating Cash Flows on Capital
Budgeting Projects
Chapter 12
Fin 325, Section 04 - Spring 2010
Washington State University
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Introduction
 Firms often face capital budgeting decisions:
when a potential project arises, a firm needs to
decide to carry on or forgo the project.
 Estimating project cash flows
 pro forma analysis: - “what is this project’s
impact on the firm’s cash flows if we go
forward?”
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Sample Project (a game development company)
 Computer Game
 Price = $39.99
 Projected unit sales:
Year
Unit Sales
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15,000
2
27,000
3
5,000
 Variable cost per game = $4.25
 Fixed costs per year = $150,000
 Startup costs:
 Software duplicating machine costing $75,000
 Shipping and installation costs of $2,000
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 Duplicating machine will be depreciated
straight-line to $5,000 over the life of the
project
 We expect to be able to sell the machine for
$2,000 after we are done with it
 The new game will cut into sales of an older
game currently on the market
 The old game will lose sales of 2,000 units per
year throughout the life of the new game
 Old game sells for $19.99 and has variable costs
of $3.50 per unit
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 Game development costs for the new game totaled
$150,000
 Net Working Capital requirements at the
beginning of each year will be 10% of the projected
sales during the coming year
 The marginal tax rate is 34 percent
 The appropriate discount rate for projects of this
risk is 15 percent
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Guiding Principles for Cash Flow Estimation
 We are interested in incremental cash flows
 Cash flow changes that we expect as a result of
accepting the project
 Some incremental cash flows are not obvious
 Opportunity costs
 Sunk costs
 Substitutionary and Complementary effects
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• Opportunity costs


Example: if we did not use an existing resource for
our project, it could have been used to generate
cash flows for another project, so our project must
be charged for those foregone cash flows
E.g. Existing machinery
• Sunk costs
 If a firm has already paid an expense or is obligated
to pay one in the future regardless of whether the
project is undertaken, it is a sunk cost and should
never be considered in the project cash flows
 E.g. Development costs
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• Substitutionary Effects
• New project causes reduction in both sales and
variable costs of existing projects
• Complementary Effects
• New project causes increases in both sales and
variable costs of existing projects
• If a new project will reduce or increase cash flows
for existing products or services then those changes
are incremental to the project and should be
included in the project cash flows
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Total Project Cash Flow
 We will use Free Cash Flow as our measure
of the cash flow available from a project
FCF  OperatingCash Flow - Investmentin OperatingCapital
 [EBIT- T axes Depreciation]
- [Gross fixed assets  Net operatingworkingcapital]
 Since we are considering potential projects, the
inputs are estimates rather than actual historical
numbers
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Calculating Depreciation
 The depreciable basis for real property is
calculated as:
Cost + sales tax + freight charges + installation and
testing
 For our project:
Purchase price
$75,00
0
Shipping and installation
$2,000
Total depreciable basis
$77,00
0
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 Since initially we are assuming straight-line
depreciation for our project:
Depreciation 
BeginningBook Value - Ending Book Value
Depreciable Life
= ($77,000 - $5,000) / 3
= $24,000 per year
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Calculating Operating Cash Flow
 OCF = EBIT – Taxes + Depreciation
 It is useful to use a pro-forma income statement
approach to calculate operating cash flow.
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Calculating the Change in Gross Fixed Assets
 For most projects we need to calculate the change in
gross fixed assets at the beginning of the project
(time 0) and at the end of the project
 At the beginning of the project the change
in gross fixed assets equals the asset’s depreciable
basis
 For our project: $77,000
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 At the end of the project:
 We need to consider the tax consequences of the
sale of the asset


If we sell the asset for more than its book value we have a
gain on the sale
If we sell the asset for less than book value we have a loss on
the sale
After-Tax Cash Flow (ATCF)
ATCF = Book Value + (Market Value – Book Value) x (1 – TC)
In our example:
ATCF = 5,000 + (2,000 – 5,000) x (1-.34)
= $3,020
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Calculating Changes in Net Working Capital
 For some projects we might assume that NWC
increases at time zero (resulting in a negative cash
flow) and decreases at the end of the project
(resulting in a positive cash flow)
 For our project, NWC changes each year
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Bringing it All Together
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Accelerated Depreciation
 Our FCF calculation used a simplistic
assumption about depreciation
 Straight Line
 In reality, firms want to use accelerated
depreciation
 More of the depreciation expense occurs
earlier in the asset’s life, lowering taxes and
increasing cash flow
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 The IRS allows businesses to use the Modified
Accelerated Cost Recovery System (MACRS) to
depreciate assets
 Incorporates the half-year convention
 Uses the double-declining balance depreciation
method
 The ultimate accelerated depreciation method
would be to expense it immediately
 IRS Section 179 deduction allows this for assets up
to $108,000
 Geared toward small businesses
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Differing Asset Lives
 If we decide to go ahead with a project, but
we have to choose between two alternative
assets, each with a different life, we can use the
Equivalent Annual Cost (EAC) method to make
the choice
Find the sum of the present values of the cash
flows for one iteration of asset A and asset B
2. Treat each sum as the present value of an annuity
with life equal to the life of the respective asset,
and solve for each asset’s payment
3. Choose the asset with the least negative EAC
1.
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EAC Example
Suppose that your company has won a bid for a new
project—painting highway signs for the local highway
department. Based on past experience, you’re pretty sure
that your company will have the contract for the
foreseeable future, and now you have to decide whether
to use machine A or machine B to paint the signs:
machine A costs $20,000, lasts five years, and will
generate annual after-tax net expenses of $2,500.
Machine B costs $12,000, lasts three years, and will have
after-tax net expenses of $3,500 per year. Assume that, in
either case, each machine will simply be junked at the
end of its useful life, and the firm faces a cost of capital of
12 percent. Which machine should you choose?
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EAC Example - Solution
One iteration of each machine will consist of the sets of cash flows shown
below:
The sum of the PVs
of machine A’s cash
flows
The sum of the PVs
of machine B’s cash
flows
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EAC Example - Solution
1.
Treating A as the present value of a 5-period
annuity, setting i to 12 percent, and solving for
payment will yield a payment of −$8,048, which is
machine A’s EAC.
2.
Treating B as the present value of a three-period
annuity, setting i to 12 percent, and solving for
payment will yield a payment of −$8,496, which is
machine B’s EAC.
3.
Since machine A’s EAC is less negative than
machine B’s, your firm should choose machine A.
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